Central banks are short financial conditions – Deutsche Bank

In view of analysts at Deutsche Bank, central banks seem to be at least partially targeting tighter financial conditions and given the composition of financial condition indices, this would imply higher volatility, lower equities, higher real rates and wider credit spreads.

Key Quotes

“For each central bank, it would also imply a stronger currency. However, if they move in unison, the extent of tightening from a stronger currency will be limited.”

“Given the current stance, the proverbial central bank put is out-of-the-money for now. In other words, central banks are unlikely to be deterred by the first e.g. 10% decline in equity prices, and are likely to be encouraged in tightening policy if risky assets remain resilient.”

“More importantly central banks can influence real rates, at the front-end via policy rates and at the long-end via QE, more directly than the other components of financial condition indices. Thus, the first order trade given the current bias of central banks would be short real rates . On this metric, the UK remains the most expensive bond market. More generally, risk premium in fixed income markets remain too low.”

“Inflation remains the one factor constraining a more aggressive central bank tightening. This is particularly true in the US where core inflation has surprised three times to the downside and the Fed is already ahead of other central banks in its tightening cycle. However, while the market has been focusing on central banks speak, oil prices have rebounded from the recent low. Also, notwithstanding the recent downside surprises to US core inflation, leading indicators still point towards core CPI and wages trending slowly up.”

“Finally valuations suggest that the risk premium is too low. We define the bond risk premium as the difference between the USD5Y5Y OIS and long-term nominal GDP expectations from the SPF. The gap between these two metrics represents the difference between potential growth and the neutral rate (ignoring potential systemic bias of long-term growth expectations). This gap is likely to be impacted by supply/demand factors as well as the inflation outlook. We account for these factors with (1) a measure of global current account imbalance (defined as the sum of all the positive current accounts) to reflect the savings glut, (2) QE flows and (3) the inflation skew (captured by the 75% percentile of the Michigan survey of inflation expectations). We define the adjusted bond risk premium as the level of the bond risk premium which cannot be explained by these factors. The adjusted bond risk premium is currently too low indicating potential for a sell-off in rates over the next 12 months. Additionally, using this framework, the Fed reinvestment taper would require 5Y5Y OIS to be ~15bp higher by the end of the year.”

“In conclusion, the market is likely to be long rates and long risky asset. Central banks are leaning against market positioning, but are constrained by the inflation outlook. And although inflation has surprised to the downside the trend implied by leading indicators is still for higher inflation. Valuations metrics suggest that the term premium is too low. Thus, from a market perspective, the risks are asymmetric to an upside surprise to wages/inflation generating a second leg to the upward repricing of the risk premium.”