Central banks increasingly are moving away from excessively easy monetary policy. Yields paused after recent gains last week, partly on soft inflation data. Yet we see them rising gradually, reinforcing the case for stocks over bonds.
Monetary tightening expectations shifted upward globally in June after markets interpreted European Central Bank (ECB) remarks as hawkish. This was reflected in a sharp rise in the gap between five- and two-year yields—a key gauge of monetary policy expectations. Germany led the move higher, as seen in the chart above.
The major catalyst for the upward shift: ECB President Mario Draghi’s June comments on the need to normalize policy. Draghi said “a constant policy stance will become more accommodative,” as easy financial conditions accelerate economic activity. We see inflation in the eurozone eventually picking up amid ongoing monetary support, a sustained global economic expansion, and an improving eurozone outlook. Accordingly, we see the ECB announcing in September that it will start scaling down its asset purchases beginning in 2018. We expect prudence and patience to guide the bank’s process for withdrawing monetary stimulus.
Elsewhere, the U.S. Federal Reserve (Fed) appears committed to normalizing interest rates further and initiating its balance sheet reduction this year. Fed Chair Janet Yellen appeared to reinforce this stance last week in Congressional testimony that we view as consistent with past communications. Also, the Bank of Canada last week raised rates for the first time since 2010 and markets expect an October rate hike.
We believe gradual monetary policy normalization and sustained global economic expansion point to moderately higher global bond yields. This supports our preference for stocks over bonds and our favoring of the momentum and value style factors. A risk to our view: global policy normalization disrupts bond markets more than we expect and significantly higher bond yields undermine economic progress and equity valuations. We view this as unlikely.
Read more market insights in my Weekly Commentary.