Recently, two major voices in the "core Fed" (Fischer and Dudley) have indicated that despite low inflation, the Fed's main scenario is to begin hiking rates in mid 2015. Economic conditions in the US warrant such and there seems to be a desire to have a more normal (non-zero) policy rate (of course, the Fed will use other vehicles, such as reverse repos to guide the market, as well). We estimated in September that the hike would be June, but we now include July as a possibility. Due to low inflation, we believe that they will be extremely slow in raising rates. The Fed prefers to hike rates in fairly predictable fashion once it gets started (therefore, at each meeting), but even 25 bps hikes per meeting might be deemed too rapid given the fragile global scenario. Thus, it is highly possible that they will take a "baby steps" approach of 12.5 bps each meeting. This would leave the Fed funds channel rate at 0.75-1.0% at year-end, which remains highly stimulative for the economy and supportive of risk assets.
As for US inflation, the CPI should decelerate to 1.2% by March (and in June), even assuming some moderate rebound in oil prices. However, shelter prices are still increasing, so core inflation will likely remain near 1.8% for much of 2015, which should give some rationale for the Fed hikes.
In Japan, the BOJ shocked nearly everyone in late October. In summer, we thought they would surprise the markets by and easing policy further, but the Yen weakened and BOJ rhetoric remained confident, so we pushed out that forecast to 2015. Mr. Kuroda, formerly in charge of Yen intervention in the early 2000s at MOF, certainly learned how to move the markets, whereas his predecessor would make moves, while bold in many ways, always turned out anti-climatic due to disappointing guidance. We, however, do not expect any further action in the next two quarters by the BOJ. Notably, there has been only limited criticism by the G-20 of the weaker Yen. Indeed, the newly appointed Treasury official on international affairs, Nathan Sheets, said that Japan's escape from deflation was critical for the global economy and, thus, supported the BOJ actions. Clearly, geopolitics are playing a role in such patience, but complaints could accelerate if the Yen quickly weakens much further. Moreover, Japan does not likely want the Yen to become too volatile. The weak macro data also caused Yen weakness, but this should reverse in the coming quarters, offsetting a part of the weakness created by diverging monetary policies with the Fed. Meanwhile, the Ex Food and Energy CPI (which we expect the BOJ to increasingly emphasize as a benchmark) continues to lose momentum (it grew only at a 0.4% 6-month annualized rate in October). As mentioned before, housing rent will be the key factor to watch.
The consensus is somewhat mixed on the ECB outlook, but, we expect it to conduct some kind of sovereign bond QE in early 2015 and if not, then in the 2Q15. It could use an indirect format/vehicle that lessens opposition to such, for instance by initially sterilizing purchases and then de-sterilizing, much as was done with the Securities Markets Programme (SMP). The Bundesbank is very reluctant to engage even in this kind of "sneaky sovereign QE," and the benefits of such are highly debateable at this stage with bond yields already exceedingly low, but Draghi seems adamant and likely has enough votes for approval. We do suggest, however, that the QE program will be moderately sized, at least at the beginning, as the ECB does not wish to dis-incentivize governments' reform efforts.
Geopolitics and Commodity Prices
As for geopolitics, the major current factor is the Saudi desire to hurt Iran and Russia (which supports Syria and Iran) by jawboning oil prices lower. It is greatly damaging its own fiscal situation and curtailing the US shale industry, so we don't expect this policy to last much longer than a few months. Once significant cuts to US energy industry capex are crystallized and, thus, US supply is capped, the Saudis should declare victory. Moreover, global energy demand should increase with low prices.
We still foresee Ukraine as a stalemate, with neither side wishing to be overly-aggressive. We don't expect sanctions or reprisals to deeply affect the global economy, although reduced supplies of Russian gas during the winter could make relations very testy. We also expect Iraq to become a stalemate, as neither side can control its rival's areas. Other risks (including China's aggressive territorial claims, North Korea, other MENA unrest, EM political strife, etc..) will likely occasionally instil fears in risk markets, but not likely lead to crisis. Given this scenario, coupled with a global economic rebound, we expect Brent oil to rise to $72 at end June and $76 in December 2015, with overall commodity prices rising moderately, as well.
Bond and Currency Targets
Due to low oil prices, very aggressive moves by the ECB and BOJ, and weaker than expected Eurozone and Japanese economic growth, G-3 bond yields fell rather than rising as we predicted in September. However, due to our view that the global economy and commodity prices will rebound, we expect yields to rise moderately for the next two quarters. For US 10Y Treasuries, our target for June-end is 2.45% (2.65% in December), while those for 10Y JGBs and German Bunds are 0.50% and 0.85%, respectively (and 0.7% and 1.0% in December). For Australia we expect a rise to 3.2% and 3.4% for these periods. This implies (coupled with our forex targets), that including coupon income, the Citigroup WGBI (index of global bonds) should produce a -0.5% return from our base date of December 8th through March in USD terms and -1.7% through June. Thus, we are not positive on global bonds for USD based investors. This index, however, should return 0.4% in Yen terms due to Yen weakness (see below) at end-March and 0.9% at end-June. We target 10Y JGBs to return -0.2% in Yen terms through June (and -1.7% through year-end), so we continue to suggest a preference for ex-Japan bonds for Japanese investors.
Thanks to Japan's large monetary easing stance vs. a tighter Fed policy, coupled with a sharply negative trade balance and higher interest rates abroad, we continue to expect the Yen to weaken in the quarters ahead. We now forecast that March will finish at 122: USD, with 124 in June and 126 at year-end. The effect (whether truly invested or just anticipated) of GPIF shifting to more towards overseas investments is also likely to continue to weaken the Yen.
Elsewhere in the Asia Pacific region, we expect the CNY to remain flat vs. the USD at June and December of next year and for the AUD to weaken to 0.80 vs. the USD for those two periods. As for the EUR, despite a high current account surplus, the "sneaky sovereign QE" should weaken the currency to 1.20: USD and 1.18 at June and December-end.