Having learned the lesson of the so called ‘Taper Tantrum’ in early 2013, the US Federal Reserve has been careful over the past year to manage expectations in the market of when it would move to end its asset purchasing programme and start to raise interest rates.
During the last quarter of 2014, the Fed confirmed that asset purchases would come to an end and that continued improvements in the US labour market would enable it to return levels of inflation to the 2% target.
At the same time, its Federal Open Market Committee stated in November that it: “anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0%-0.25% target range for the federal funds rate for a considerable time following the end of its asset purchase programme this month, especially if projected inflation continues to run below the Committee’s 2% longer run goal.
In brief, the picture is that interest rates will rise, albeit slowly, as the US economy continues its recovery. This also opens up a significant shift in direction by the Fed versus the direction of the European Central Bank (ECB) and Bank of Japan (BoJ), where additional quantitative easing (QE) has either not been ruled out (ECB) or indeed seems to have become a cornerstone of government policy (BoJ) intended to induce inflation.
The question thus posed to investors is whether the coming year could become one in which these increasing differences between developed market regions lead to a significant rotation from fixed income to other asset classes.
Such a ‘Great Rotation’ was much flagged up a couple of years ago. This did not happen – particularly among European investors as evidenced by ongoing levels of net new inflows to bond funds across the region – even as US and other equity indices soared.
David Zahn, head of European Fixed Income, Franklin Templeton Investments, says that the trend emerging is of the eurozone having more in common with Japan than either the US or UK.
“In the United States, the Fed has indicated it is going to stop its QE programme…and its next focus will be on when to raise interest rates.”
“That’s a strong differential to make, and it has ramifications for the currencies. We think the euro should probably weaken against the dollar and, to a lesser extent, the pound — it has already weakened quite a bit against the pound — because the economies are on different trajectories. That might suggest to investors that European bonds may be a good place to look for potential opportunities. In our portfolio, we have taken a long-duration posture in Europe.”
Stephanie Flanders, chief market strategist for Europe, JP Morgan Asset Management added that: “We don’t see a so-called ‘Great Rotation’ being a direct symptom of diverging central bank policy. In our views, there are really three key implications: a stronger US dollar, continued weakness in global commodity prices and looser monetary conditions globally.”
“The contrasting outlook for growth and policy on different sides of the Atlantic is well demonstrated by the 1.5 percentage point gap that has opened up between the 10-year US Treasury yield and the equivalent German Bund yield. Both the real and nominal yield differential is greater than it has been since 2009. But it is by no means the largest gap we have seen in modern times.”