FOMC Preview: Committee will still view risks as to the downside – The Fed is widely expected to keep policy rates on hold at the conclusion of the December FOMC meeting on Wednesday. The focus for markets will be on changes to the policy statement, the quarterly projections, and Chair Powell’s press conference. Broadly speaking, we expect the Fed to reiterate its comfort with policy as it is, with little change in the projections. In the October FOMC minutes, for instance, ‘most’ participants judged that current policy would remain appropriate “so long as incoming information about the economy did not result in a material reassessment of the economic outlook.” Nonetheless, the minutes also told us that the Committee continues to see risks as tilted to the downside, and we expect the Fed to keep the slight easing bias in its policy statement by retaining the ‘uncertainties remain’ qualifier to the outlook, given the continued lack of clarity on US-China trade negotiations, and weak global growth. Macro data in the US since the last meeting has also been mixed; while the jobs data last Friday were strong, the manufacturing sector remains very weak according to the ISM survey, and falling imports suggest softening domestic demand. Moreover, weakness in manufacturing seems to be spilling over to the services sector, according to the nonmanufacturing ISM survey. Ultimately, this should dampen consumer spending going into the new year, and our 2020 growth forecast is well below the Fed’s, at 1.3% versus 2.0%. As growth indicators come in weaker than the Fed expects, we think this will push the Committee to ease further, with one more rate cut likely in Q1. (Bill Diviney)
Euro Rates: Struggling for direction – Markets of late have been mainly driven by headlines rather than macroeconomic fundamentals. After this Thursday’s ECB meeting and press conference, the first for Ms Lagarde, we expect market liquidity to further deteriorate as we approach year-end. This will make it even more difficult to interpret market movements. In terms of strategy, we expect yield movements to eventually revert to being driven by weak macroeconomic fundamentals and weak inflationary pressures, and the corresponding ECB’s reaction function. We therefore still favour a long bias in European government bonds, as we judge that core inflation is still far away – and will remain far away – from the ECB’s ‘close to but below 2%’ inflation mandate. We expect the ECB to lower its forecasts for growth and inflation in its December projections. Indeed, our own forecast for growth and inflation have been below the ECB’s projections for a considerable time. We therefore expect yields to move lower in Q1 next year, and we would look through the typical directionless movements in the December month.
Further ahead, we judge that long-end France looks attractive given the macroeconomic backdrop, and our expectations of an increase in asset purchases by the ECB to EUR 40bn a month to be announced in March next year. Besides our favourable view for long-end outright positions in core/semi-core government bonds, we also anticipate a flattening of the Spanish yield curve, which is steeper compared to AAA/AA government bond yield curves such as Netherlands, Germany, Belgium and France for example. As a result, this position benefits from a move lower in yields, but it also allows for additional returns from carrying the bond and rolling down the yield curve as the position is held over the coming months. Additionally, based on our fair value estimate, we judge that the 10-year Spanish yield is relatively high vis-à-vis comparables such as Portugal. (Fouad Mehadi and Jolien van den Ende)