Allocation Update: Inflation fears recede temporarily

• Inflation and rate hike fears have backed down in the past month, but with the economy continuing on the recovery track we think the retracement is just temporary
• The sell-off in commodity prices appears to be a correction of speculative excesses, rather than a sign of weakening growth expectations, and is rather a buying opportunity
• The severe problems of the Euro area debtor countries seems to be increasingly contained and thus have little impact on the overall market outlook

 Inflation fears corrected

The past months have seen inflation and rate hike fears recede clearly. Government bonds have recovered somewhat, while commodity prices have seen a sharp sell-off. We see this pullback as temporary. The trend is still towards rising inflationary pressures and further rate hikes. We thus continue to overweight inflation, and after the pullback in commodity prices commodities appear even more attractive.

Rate hike fears have calmed on both sides of the Atlantic. The Fed calmed fears of rate hikes by signalling they will continue to hold rates low for an extended period of time. The ECB also helped somewhat by sig-nalling that they will not hike rates yet in June.

The market still prices in a fair amount of rate hikes in the Euro area. The fear of rate hikes in the US re-mains extremely subdued. Two-year swap rates are merely 50 bp above the Fed funds target, which is clearly out of line with the still solid economic development. We thus think the risk for interest rates remain on the upside, with rising rate hike expectation in the US likely also to boost especially longer term bond yields in the Euro area.

Growth expectations remain robust

The sharp sell-off in raw material prices last week was not matched by any similar sell-off in equities. Thus it is hard to explain the sell-off as reflecting increasing concern about the global economic outlook. Rather it seems that a reversal of speculative long positions across commodity markets was behind the move. The trigger for this appears to have been the strengthening of the dollar after the ECB failed to signal an imminent rate hike.

The divergence of commodity prices and equities could be supported by a slowdown in heavily raw-material consuming Asian economies. That would help dampen the upward pressures on raw material prices, and help to support the recovery in the Western economies. Indeed, there is a clear slowdown in Asia underway with monetary policy being tightened in the growth economies and the Japanese earthquake dampening industrial activity.

We still expect the slowdown in Asia to be modest and at least partly temporary. The Japanese economy is likely to rebound as the situation stabilises and reconstruction work commences. Meanwhile, in China the tightening of monetary policy does not appear sharp enough to strangle the economy, but only to provide the desired downshift in growth.

Thus we continue to see a further rise in raw material prices, especially oil, as a main risk to a continued benign development of financial markets. With some of the speculative air now having evaporated from commodity markets the timing to purchase commodities as a hedge against a raw material price shock now looks clearly better.

Euro area debt problems still a sideshow

A lot of focus recently has again been on the Euro area debt problems, with speculations about an eventual Greek restructuring rising to record levels. The deepening troubles have not produced any broader turmoil. Portuguese and Irish risk premiums have followed Greek premiums to new highs. However, Spanish spreads have risen only modestly in the recent turmoil, and remained clearly below the peaks seen late last year.

It also appears that the market is not too concerned about a haircut on Greek debt causing any larger turmoil in the banking sector. The swap spreads on the bonds of Euro area financials are close to their lowest since the financial crisis. This is in sharp contrast to the situation last spring, when the sovereign debt troubles caused also financial spreads to soar.

A restructuring of Greek sovereign debt is in itself unlikely to cause huge solvency problems for Euro area financial institutions outside Greece. Financial institutions with excess exposure have had ample time to prepare themselves. Additionally, the sharp reaction in the spring of 2010 was also largely driven by extrapolating the spread of a Greek default to other countries, including Spain.

Even if the solvency of financial institutions is not threatened, their financing may still dry up if panic spreads in the market. The fact that financial spreads have not strongly reacted to sharply rising fears of a Greek restructuring strongly suggests that a market panic affecting Euro area financial institutions more broadly is unlikely. Without a more widespread turmoil in the financial markets, the broader economic impact of the problems in the indebted countries remains limited.

Other news

Week ahead: Central bank intervention looming?

18 May 2012 | Jan von Gerich

All eyes remain on anecdotal news on how depositors in Greece and outside the country are reacting to the recent events. In terms of economic data releases, the main focus will be on flash PMIs for May.

China: PBoC cuts reserve requirement rates

18 May 2012 | Annika Lindblad

The central bank (PBoC) cut reserve requirements by 50 bp last weekend, thus continuing to ease monetary policy. However, the pace remains slow, and we do not think the PBoC is done yet.

Government Bond Market Update

18 May 2012 | Gaute Langeland

The upcoming auction has potential to disappoint. Positioning in the market is less supportive than it has been for a long time as dealers are no longer short and unlikely to continue buying much more supply at current levels.