Inflation/Deflation
The Fed delivered a "hawkish hold." Remain tactically short U.S. equities and position for a stronger dollar. Meanwhile, the Bank of Japan laid out a radical overhaul: The new framework is consistent with price-level targeting and debt monetization. Long-term investors should position for a weaker yen and higher Japanese equity prices. Also, stay structurally underweight Japanese bonds: Zero is a resting point, rather than a final destination, for 10-year JGB yields.
Today's dangerous distortion does not result from credit excesses. It results from an irrational mispricing of risk caused by a protracted period of ultra-loose monetary policy. In turn, the ultra-loose monetary policy results from the dangerous dogma of the 2% inflation target. How should investors position short-term and long-term?
Wedged between an improving labor market but icy global conditions, the Fed may be on the verge of conducting a policy mistake. This would be dollar and yen bullish. Commodity and EM currencies should bear the brunt of any pain. The pound's upside is limited, but so is the downside. NZD should soon buckle. Draghi did nothing, yet the euro rebounded little.
Conditions are falling into place for inflation to plunge and monetary easing to progress rapidly. This in combination with structural reforms creates a bullish backdrop for Argentine financial markets. The current economic, structural and political configurations look more promising for Argentina than Brazil. Go long Argentina/ short Brazilian sovereign credit, overweight the Argentine bourse versus the Frontier Markets benchmark and, go long the Argentine Peso versus the Brazilian <i>real</i>.
The neutral real rate of interest, r*, is likely to remain depressed for the foreseeable future. The Fed is likely to take additional incremental measures to boost long-term inflation expectations, including allowing inflation to overshoot its 2% target more frequently. This should be enough to keep long-term Treasury yields on a gradual upward trajectory.
We put the odds of a Fed rate hike this year at slightly better than 50/50. But in the event of a rate hike, any sell-off in risk assets will be relatively short-lived and not as severe as the sell-off that followed the initial rate increase last December.
True inflation rates in the euro area and in the U.S. are actually not that different, making the polarized divergence in expected monetary policy very difficult to justify.
Most scenarios point towards higher Japanese bond yields with valuations overstretched. Maintain a maximum underweight stance on Japan in global hedged bond portfolios.