- Revenge of the NIRPs. The Bank of Japan’s (BoJ) surprise expansion of its policy accommodation to include Negative Interest Rate Policy (NIRP) sparks a reassessment of where the interest rate floor might lie for the Federal Reserve. Bond markets in January priced out virtually all expectations for normalization in 2016, leading to some speculation on negative rates should the Fed need to shift to an accommodative stance.
- The Limits to Monetary Policy. BoJ Governor Haruhiko Kuroda says, “It is no exaggeration that QQE with a negative interest rate is the most powerful monetary policy framework in the history of modern central banking.” ECB President Mario Draghi reminds us that “there are no limits to how far we are willing to deploy our instruments.” A closer look, however, reveals real vulnerabilities in these arguments.
- Consequences of the Collapse. With “V-shaped” recovery expectations for commodity prices from last year being replaced by “L-shaped” expectations, the consequences register in credit markets. Lower long-run cash flows lead to greater leverage, credit risk and now, in recognition of those facts, downgrades. This fallen angel supply adds to the valuation concerns for the higher-quality section of the high-yield market and we remain cautiously neutral.
Strategy and outlook
Delaying Fed normalization and the prospects of pricing in some even remote possibility of negative interest rates represents a meaningful inflection point to the outlook. While monetary policy alone cannot, in our assessment, address the fundamental issues underlying today’s credit cycle—excess capacity in the commodity sectors—the possibility of easing the pressure of a stronger dollar on weakening commodity prices and shrinking liquidity may for a short time relieve some of the negative sentiment that our longer-run outlook reflects. As such, we recommend some tactical adjustments to our strategy. Those flip our yield curve outlook to favor the short end of the curve over the long end, as any further easing of expectations for Fed normalization should continue to benefit this segment of the market. Reducing those expectations further reduces pressure for a stronger dollar. And that favors non-USD fixed income investments as well as emerging market debt. We moved up our recommendations last month on DM non-USD on this possibility and tactically for this month move to overweight. EM external sovereign debt may also benefit so we upgrade that segment to neutral from underweight but due to their greater vulnerabilities leave corporate EM at underweight.