Hawkish tilt by Fed and BoC flattens yield curves and threatens global equities – AmpGFX

It is interesting to note that both the Canadian and US central banks were hawkish this week despite significant falls in their key underlying inflation readings in recent months, explains the analysis team at Amplifying Global FX Capital.

Key Quotes

“These central banks have paid more attention to evidence of stronger economic growth, in the case of Canada, and a relatively tight labor market in the USA, tending to see the setbacks in inflation as temporary.  The market, on the other hand, may be beginning to wonder if the low inflation outcomes, including low wages growth, will persist for much longer, and force these central banks to delay further tightening.”

“A result of a more hawkish Bank of Canada and a Federal Reserve persisting with its steady, albeit gradual, policy tightening in the face of weaker inflation outcomes and lower oil prices, is that yield curves are flattening.”

“Even in the UK, where inflation has accelerated in recent months, its yield curve has flattened significantly reflecting the increased fear over the economic outlook as growth begins to wane and Brexit uncertainty rises in the wake of the UK election.”

“Flatter yield curves in this instance might be regarded as tightening monetary conditions.   Low bond yields have probably helped underpin global asset prices; including equities and house prices.  However, flatter yield curves have tended to damp performance of bank shares, and weaker energy prices have undermined energy shares.  IT shares have powered the global rally in equity markets this year, but they are showing signs of peaking from what might be regarded as over-bought levels.”

“Growth and earnings optimism has increased this year, supporting the rally in global equities.  Persisting low global bond yields have probably also helped boost equities overall.  However, from more elevated levels, especially for the technology sector, equities may now be more vulnerable to factors that might cause a correction.”

“Factors that may trigger a correction include ongoing Fed policy tightening, even if inflation may have fallen again well below target, and lower oil prices that begin to threaten the energy sector.  Bank shares may also struggle if curves continue to flatten.”

“A weaker USD trend, related to falling US bond yields may have also boosted capital flows to emerging market bonds and equities.  However, if the Fed appear willing to push on with their policy tightening in the face of weak inflation, it may bolster the USD and dampen recent enthusiasm for EM assets.”