Economic uncertainty hasn't declined in recent months, quite on the contrary. The consequences of Brexit, the upcoming referendum in Italy on constitutional reform, US elections, the ongoing slowdown in Chinese growth despite the important efforts to boost activity, etc. Yet corporate and emerging market bond yields have declined significantly in recent months, sovereign spreads in the Eurozone have narrowed and US equity markets have made new highs. To a large extent this is linked to the actions and credibility of central banks. The forceful reaction of the Bank of England to the prospect of a Brexit-related worsening of the real economy gave a boost to market sentiment. The ongoing QE by the Bank of Japan and the ECB have influenced global liquidity conditions and hence investor behaviour even though the former had disappointed at its most recent meeting by not going beyond buying more ETFs whereas the latter has tried to calm down market speculation of imminent new action. In both cases, this makes the September meetings even more important. The yen is flirting with the 100 level against the dollar and we can expect that the BoJ will not want to see it going lower because of the impact on the stock market and the inflation outlook. The ECB is widely expected by the market to do more considering the very subdued underlying inflation dynamics, but what exactly is not clear nor is the timing. At a minimum one would expect an extension of the QE programme beyond March 2017 but in addition some of the constraints it is facing will have to be eased so as to be in a position to implement the QE extension. Here again, the exchange rate looks like the key instrument which will reflect shifts in sentiment on what the ECB can or is likely to do.
William De Vijlder draws a picture of today's economic landscape and analyses the possible implications for the long run.
Of course, the exchange rate is a relative price of two currencies, so the Federal Reserve stance will also be a driver, not to say the most important one. Indeed, the second semester shapes up better on the growth front than the disappointing first half of the year and the pace of job creations has been well above what it needed to stabilise the unemployment rate, which is already very low. Unsurprisingly, the tone has become more hawkish and the debate amongst economists has shifted from the possibility of a new hike to the timing of such a move: September or December? Yet, the fixed income markets are not fully pricing in a move between now and year-end. It is tempting to label this as complacency, but it can also reflect international influences. Global spillovers of domestic monetary policy are a well-known phenomenon and since the global financial crisis, there have been many analyses showing the impact of Federal Reserve policy on the interest rates and exchange rates of other countries. What seems to be rather new is that it also goes in the other direction. When bond yields are negative in an increasing number of countries and for ever longer maturities, US yields end up looking pretty attractive even though in the absolute they are also low. In a way this weighs on the influence of the Fed on the long end of the yield curve. Another factor which contributes to keeping US bond yields low is the Fed's credibility: investors are convinced that it will not rock the boat and hence will be very cautious in hiking rates. The growing emphasis of Fed officials on the neutral rate of interest being very low goes in the same direction. The neutral rate is the rate which neither stimulates nor slows down the economy. A low neutral rate implies that the cumulative tightening in this cycle should be limited and hence should not cause any disruption to speak of in the real economy. This would imply that the prospect of a Fed tightening later this year becomes less of an issue.