Financial markets are heavily distorted by the unprecedented market presence of central banks. Markets have become extremely sensitive to changes in central bank actions.
The European Central Bank (ECB) is walking a fine line as it tries to exit quantitative easing in Q4 and tweak its rate guidance for 2019.
Meanwhile, US dollar weakness rooted in net external liabilities worth 40% of US GDP - double the level that prevailed on the onset of the financial crisis ten years ago - has the potential to spoil the party.
Even if the ECB scaled down asset purchases to €30bn a month starting in January, monetary stimulus looks increasingly at odds with robust growth in the euro area. Public deficits will be less than 1% of euro area GDP in 2018.
Continued ECB bond-buying will further shrink the pool of assets available for markets, to the tune of €130bn for sovereign debt markets alone. Pressure on yields and spreads is indeed unabated. Meanwhile, several sovereign issuers have been upgraded.
There could be more to come in March and April (Portugal and Spain). As sovereign spreads move in lockstep, Spain could soon trade on par with A-rated Ireland. There is no question that Spain and Portugal bonds, including credit, will remain in high demand until spring.
So what could cause the bond rally to derail? It looks like dollar weakness could be the game changer. Markets could test the ECB's commitment to put an end to asset purchases later this year.
In the US, the Fed is engaged in planned balance sheet reduction and gradual Fed funds rate increases, which should be supportive of the dollar.
But overblown US external imbalances, induced in part by quantitative easing in Japan and the euro area, highlight the risk of a materially weaker dollar. Imbalances are likely to worsen as fiscal policy eases.
A lower dollar would also raise imported inflation at a time when the economy is operating at full employment. In the context, Fed policy could turn considerably more restrictive than anticipated. Higher US Treasury yields would pull global yields higher.
In the euro area, Bund yields would follow on the upside with likely implications on investor demand for higher-risk assets.
Axel Botte is fixed income strategist at Natixis Asset Management
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