Last week started with rumours that the UK would formally trigger the process of leaving the EU on Tuesday. However, before Theresa May’s government could trigger Article 50 she had to finish the legislation in parliament that gives her the right to do so. Although the government was given a relatively easy ride by parliament initially, with regards to triggering the process, it has since suffered 2 defeats in the House of Lords. The amendments, on whether parliament should have a vote on the final Brexit deal and a guaranteeing of the rights of EU nationals in the UK, were debated on Monday and sent back to the House of Lords, where they accepted the supremacy of the Commons. It has since been declared that the UK is to trigger the Brexit process on March 29th.
On Wednesday we had a clear case of ‘sell the rumour, buy the fact’, when the FOMC raised the Fed's funds rate target by 25bps sparking a rally across the US Treasury (UST), stock, emerging market forex, as well as Latam, Middle East and Far East bond markets. The rate hike was followed by a much more dovish Fed statement than was previously expected. In the post announcement press conference Fed Chair Janet Yellen stated, ’It is likely that target policy rates will go up in line with their forecast. As such we don’t expect any acceleration in the pace of hikes as long as economic developments remain on track, as a result, we maintain our monetary policy outlook, expecting two more hikes this year and two more next year’.
Of course the market remained sanguine regarding these further rate hikes, and continues, as it has over the last two years, to have lower rates priced in. If we look at the medium of the Fed's ‘dot plot’ path they have indicated Fed funds rates at 2.25% by year-end and 3% at the end of 2018, much higher than the OIS (Overnight Indexed Swap) priced by the market; which implies around 1.35% at the end of this year and just 1.75% at the end of 2018. Strikes us that if the Fed does enact two more hikes this year, consistent with their current path of just 25bp per move, that puts the higher band of the Funds rate at 1.5% not 2.25% as inferred by the ‘dot plot’ medium path and so this indicator looks to be an inaccurate measure given Yellen’s statement.
As mentioned above, UST rallied across the curve sparking a global bond rally with 5-year yields 13bps lower, now trading at around 2%, and 10-years 11bps lower, now trading around 2.5%. Basically, we have been saying the market was oversold coming into the meeting as 10-year UST yields had moved up around 20bps since February month-end and at this morning’s levels we now make UST rates at fair value given the economic and political outlook for the up-and-coming Trump budget etc. Broadly, we feel there is a risk premium already built into current pricing although we still see the longer-end of the yield curve as the best value, and with the highest potential return on a risk adjusted basis.
Elsewhere, Chinese economic data releases added impetus to the country's growth momentum. February’s industrial production (IP) release beat market expectations, accelerating 6.3%yoy; boosted by manufacturing and utility sectors. Fixed asset investment (FAI) also exceeded expectations coming in at 8.9%yoy, from 8.1%yoy in January. Meanwhile, retail sales fell short of the market consensus (although still stood at 9.5%yoy) driven by a fall in auto sales; this was possibly due to overbuying of cars in 2016 ahead of the reduction in tax incentives on low-emission cars this year.
The property sector, which has been somewhat of a concern, has also shown signs of moderate recovery with property investment gaining 2% to 8.9%yoy. According to China’s National Bureau of Statistics, third- and fourth-tier cities have benefited from the recent increase in property sales which is in-line with policymakers’ push to reduce inventory in the lower-tier cities: part of the five economic tasks of 2017.
Earlier this month at the National People's Congress (NPC) it was announced that China’s growth target was officially lowered to 6.5% (from 6.5-7%). With the recent bout of positive data prints, and all else being equal, we do not expect the economy will struggle to achieve this level of growth, and could in fact exceed it. However, the government would not want the economy to overheat, nor push for growth just so that a target can be achieved, rather continue on its path of more quality and sustainable growth while identifying and managing financial risks.
No doubt the growth rate will determine the monetary and fiscal policy mix. We expect policymakers to maintain a bias towards proactive fiscal policy, especially as monetary policy is constrained as the PBoC looks to stem capital outflows. The lowly 3% budget deficit as a percentage of GDP this year gives the government sufficient room to deploy all number of quasi-fiscal measures to maintain growth targets: if for example inflation spikes and the central bank has to tighten.