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Monday 20, March 2017 by Georgina Enzer

ENBD CIO weekly: Not so hawkish

The Ides of March (15 March) in the end finished with a whimper. Fears of a marked increase in hawkishness by the Fed proved wide of the mark, while the Dutch Freedom party failed to achieve its goals in the general election.

The reinstatement of the debt cap in the United States will however over the medium term cause quite a headache for Donald Trump’s ambitions to up spending.

The US Federal Reserve Open Market Committee (FOMC) as universally expected by the market raised policy rates by 25 bps, and signalled two more potential rate increases this year and three in 2018. The Fed Chair Janet Yellen highlighted that the US economy continues to grow at a healthy clip, while international risks had abated. However, in contrast to an expected more hawkish tone in the minutes of the meeting, the Fed indicated it hasn’t fallen behind with its efforts to keep inflation in check and hence they did not accelerate the timeline for further rate increases. Financial markets promptly reacted by marking up both bonds and equities.

GCC Central Banks largely followed the Fed by increasing official policy interest rates by 25bps. Market rates had largely discounted the rate rise, hence one-month EIBOR (UAE) was just 5bps higher on the week at 1.02 per cent; 1mth SAIBOR (Saudi) ended the week at 1.34 per cent, plus 4bps on the week. Although Saudi rates are above those of the UAE, they have fallen sharply from the 2.10 per cent level that prevailed in October on liquidity concerns. Indeed, for Saudi Arabia the level of one-month market rates is the lowest since the early days of 2016.

GCC economies will have appreciated the weakness of the dollar in the wake of the Fed meeting. The trade-weighted dollar fell by about one per cent on the week. The dollar is now down three per cent from its peak in December. Traders’ long dollar positions remain elevated by historical standards and hence any weakness in US economic data from here could lead to a potential two to three per cent sharp setback for the dollar.

Sterling was one of the chief beneficiaries of dollar weakness, with the pound recovering from the crucial $1.21 support to end the week close to $1.24. We continue to expect sterling to hold above the $1.21 level, despite the ongoing messy logistics of the UK invoking article 50 that sets a two-year timetable for the UK to leave the EU.

The euro benefitted from the results on the Dutch general election that showed only modest gains for the far-right Freedom party. Against the previous worry that the Freedom party could win as many as thirty seats in parliament, they ended with just twenty, but they still moved up to be the second largest party. The euro is at the top end of the recent trading range of $1.04 – $1.07.

Elsewhere around the world, the People’s Bank of China (PBoC) was the other notable quasi dollar linked central bank to need to adjust rates post the Fed meeting. Whilst benchmark interest rates remained unchanged they did endorse a 10 bps increase in market rates. The move was an attempt to curb capital outflows by easing downward pressure on the renminbi, while avoiding a marked tightening of monetary conditions in the real economy, as most loans are linked to the benchmark rates. The Central Bank emphasised that open-market interest rates are mainly driven by market supply and demand, hence allowing them to rise does not equate to interest rate hikes. The decision not to raise official rates but to allow market rates to drift higher was largely expected by investors. While in the short term the Central Bank has room for the further tightening of interbank rates, given the recent strength of the economy and factory inflationary pressures, the PBoC remains concerned that rising interbank rates could jeopardise the shadow-banking system. Non-bank financial institutions, which tend to invest in less liquid and longer-maturity assets, have increasingly resorted to wholesale money-market funding in China. The obvious maturity mismatch of these non-bank institutions, ranging from asset managers to leasing firms, could see the day of reckoning should money-market rates rise too fast.

Although the Fed and the PBoC tightened their policy, the Central Bank of Japan left policy on hold. The BOJ decided to keep its two key rates unchanged and to continue with the current pace of asset purchases. In spite of years of a record-loose monetary stance, inflationary pressures remain subdued and consumption languishes. The recent improvements in the economy, with Japan at end of last year recording five back-to-back quarters of positive growth, can be put down to a global reflationary cycle boosting Japanese exports and investments. Inflation gains, driven by a weakening yen and rising crude prices, will not continue indefinitely and rising exports might be challenged by Trump's protectionist policies. In the land of the rising sun, domestic demand shows no signs of meaningful improvement, as wage increases remain too modest to dent a deeply entrenched deflationary mentality which thwarts consumption. Rising bond yields in the US and in China will ultimately put pressure on Japan's policy rates and on the yen, making the BOJ's task to keep the economy on an expansionary path no easier. While for the current year robust global growth should see Japan chug along, in the longer run neither the BOJ nor the government seem be able to provide valid antidotes to the country's malaise.

In the week ending March 15, EM bond funds witnessed modest capital inflows and saw credit spreads tighten post the Fed fund rate increase on the back of dovish remarks by Chairperson Janet Yellen. Capital inflows to Emerging asset markets alongside improving macroeconomic fundamentals support our view that a further tightening of credit spreads by circa 50 bps is possible over the near to medium term. The surge in demand on the primary activity front for EM debt underpins our technical support for such a tightening. Global investment grade bonds remain supported by US benchmark government bonds yields, which have held in a holding pattern sub 2.5 per cent failing to breach the recent 2.63 per cent high. Although global IG spreads are close to their richest levels, there seems to be evidence that at 115 bps strong investor demand could be the catalyst for further spread compression, as pressure on the underlying benchmark government yields have, at least for the near term, abated.

In EM, as expected the central bank of Turkey raised the late liquidity lending rate by 75 bps to 11.75 per cent, leaving the other three key rates unchanged. In Russia, a recent surge in primary activity on US-dollar corporate debt lured investors globally, as participation remained at the forefront after the successful bond sales by Russian Railways, Alpha bank, Evraz Group and the most recent Gazprom Bank. He latter priced their $750 million, ten-year loan participation notes to yield at 4.95 per cent. Within LATAM, the United Mexican states also sold 10-year sovereign notes last week and their EM Asian peer - the republic of Indonesia - is currently meeting fixed income investors for a potential sovereign Sukuk sale.

Our conviction positive view on Indian asset markets grows stronger by the day, as investors absorb the enormity of the impact of the landslide victory of the BJP in the Uttar Pradesh elections. We believe that a Nifty 50 target of 1050 is quite possible by the end of the year, representing 11 per cent upside from current levels. As I listened to a BJP spokesperson speak this past week, it is very evident that the scale of the win came as a surprise even to the BJP leadership. There are few countries in the global investment universe that offer the strong underling demographics that India has in place alongside the political leadership energising a reform programme on the scale that India appears to be delivering. Goldman Sachs note that the equity market trades at a five to 10 per cent premium to long term average valuations. However, with upgrades to corporate profit forecasts yet to really kick in, with foreign investors only just waking to the impact of the UP elections, with interest rates still at elevated levels and with valuations able to stretch into more extreme territory, the upside could be substantial and 1050 on the Nifty 50 can be considered as a potential year-end target.

We see likelihood of increased foreign fund flows into Indonesian Equities. An S&P upgrade on Indonesia’s credit rating looks imminent, as non-performing loan growth continues to moderate, the fiscal deficit narrows and tax revenue growth improves. Execution of fiscal spending plans has also improved, alleviating the key concerns highlighted by S&P as it decided to not upgrade the country last June. Post an upgrade, the lower perceived risk of Indonesia could drive some spread tightening versus US treasuries, thereby reducing capital flight risk. Steadily rising foreign reserves to $113bn in February should help dampen Rupiah volatility. Financial markets seem to be already alert to these changing winds, as evidenced by the rally last week in financial and consumer stocks, with Bank Rakyat (+7.6 per cent) and Indofood Sukses (+5.1 per cent), our preferred financial and consumer picks.


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