A Long Leash for Central Banks

Bond Market Outlook

A Long Leash for Central Banks

Subdued core inflation allows central banks a very long leash to keep interest rates low. Further interest rate hikes are likely off the table until growth picks up enough to push inflation rates higher.

“Less is only more where more is no good.” ~Frank Lloyd Wright


  • The most underappreciated economic theme continues to be the extraordinarily subdued inflation rates around the globe.
  • Fed officials are making it clear that conditions must change substantially before they will commence further rate increases.
  • Considering the recent downshift in global growth, both the US and China have strong incentives to reach a bargain on trade.
  • The challenges that hit EM last year have led to EM local debt being priced at an 18-year low.
  • We believe the severe underperformance of spread sectors to global sovereign bonds last year presents a very meaningful opportunity.



Our view is that the US and global expansion will continue, albeit at a very slow pace, allowing a sustained rebound in spread sectors. Underpinning the recovery will be the continuing primary (to the point of being exclusive) focus by monetary policymakers on the need to extend the expansion.

Global Low Inflation

We also believe the most underappreciated theme continues to be the extraordinarily subdued inflation rates around the globe. In the US, the Federal Reserve (Fed) has missed its inflation target and forecasts for each of the last seven years and looks ready to add 2019 as its eighth. Nine years into the US expansion and inflation has yet to reach the Fed’s 2% target, despite massive monetary and fiscal stimulus. The global inflation rate, which flirted with zero as recently as 2016, has once again been subject to downward revisions after the 2017 and early 2018 bounces. Below-trend core inflation allows central banks the very long leash to get and/or keep interest rates low. And until growth picks up substantially enough to bring these inflation rates back to life—rather than central bank forecasts that they may come back to life—interest rate hikes are off the table.

In today’s debt-laden subpar expansion, monetary policy endeavors to stay accommodative until growth resurges and presents an opportunity to restart normalization. Then very modest incremental changes can be enacted, with constant vigilance to stop should growth stall. In the US, the window of opportunity to raise rates looked wide open with the economy accelerating to over 3.5% growth (annualized) in the middle two quarters of the year.

Inching the fed funds rate up three times seemed non-controversial. But by December 2018, the US economy was downshifting quickly and the global picture was also weakening. In this environment, a Fed pause was called for. Having guided the markets so clearly to expect a December hike, the Fed followed through, but then executed a pause to a “wait-and-see” approach. The Fed clearly expected that the fed funds rate level would be at the very low end of “the normal range.”

It is not absolutely clear cut, though, that today’s rate is at the bottom of that range. In addition to below-target inflation, growth in 4Q18 may come in close to 1% and 1Q19 is off to a slow start. Maybe, as we expect, this lull in growth is temporary. It is also possible that the fed funds rate is already sufficient.

The primacy of the objective of extending the expansion means that a high degree of certainty must be attained before tightening can re-commence. Some Fed members seem confident that such conditions may come back into evidence. But the leadership of the Fed, what might be lightly dubbed the “holy trinity”—The Fed Chair, Vice Chair and NY Fed president—are all on message. They are dutifully nudging market participants to understand that conditions must change substantially. John Williams, President of the New York Fed, made this point explicitly this week: “…but it would be a different outlook either for growth or inflation” to return to hiking rates. This echoes Fed Chair Jerome Powell’s comments at his January press conference: “…I would want to see a need for further rate increases….” The economy will have to pick up speed for an extended period, bringing inflation with it, before the Fed will tighten again.

Globally, monetary policymakers have been in a more accommodative mode than the US has been in for quite some time as growth and inflation remain below target levels. Indeed, the fear here is that growth will continue to weaken. It was the global weakness, in conjunction with fears of sustained US monetary policy tightening and a potential trade war, that caused risk assets to perform so badly last year.

The question then becomes, “can growth remain sturdy?” European growth is off to a very slow start after last year’s downshift to trend from above-trend growth in 2017. Chinese growth continues to be soggy. Japanese growth downshifted, and non-China emerging markets (EM) are trying to shake off the negative effects of last year’s brutal combination of both downwardly revised global growth and higher US interest rates. Clearly the need to monitor further downside challenges is acute. However, some of the factors that drove last year’s extreme pessimism are fading.


Two negatives that may be abating revolve around China. Coming into last year, Chinese policy was in a deleveraging mode as the debt burdens and shadow banking system were being reduced. Belated recognition and an early underestimation of the severity and probable longevity of the trade and economic tensions with the United States led to further shortfalls in growth. But the need to shore up growth as the challenge of competition with the US becomes more pronounced has led to extensive policy stimulus.

China has cut interest rates and reserve requirements. It has cut individual tax rates and moved to increased fiscal stimulus. Most tellingly, China has very publicly trumpeted the need to reinvigorate the private sector, virtually reversing last year’s program of squeezing private sector borrowers. These policy measures will take hold with a lag, and therefore economic indicators may not turn decisively up for some time. But a long rounding bottom is our base case for China, with growth in the second half of 2019 being better than in the first.

In conjunction with the better economic outlook, the prospects for a dampening of the trade tensions that were so disruptive to global growth seem to be in store. The politics of slamming China publicly played well as long as there was little actual or perceived cost. But with the downshifting of growth, both the US and China have strong incentives to reach a bargain, and have been signaling the likelihood of such an outcome. We do not expect such a deal to come remotely close to resolving all the issues, and expect the economic competition to be a central theme going forward. But we do expect the attenuation of investment projects as uncertainty mounted late last year will subside.


We expect modest, close-to-trend growth of 1.25%-1.5% in Europe. Last year, the European downshift in growth was additionally clouded by Italian reticence to accommodate EU budgetary rules, the continuing saga and risk of Brexit and political turmoil in France. The question is whether worst-case tail-risks in these countries will come to pass. Brexit remains unsettled, but our team continues to expect that a “hard Brexit” will be avoided. (We delve more deeply into our views on the topic in Gordon Brown’s recent paper, Brexit: Deal or No Deal? Or Something in Between?) In Italy, despite its limping economy, the Italians’ willingness to play ball with the EU keeps the European Central Bank on its side. And in France, recent economic perkiness may reinforce the notion that chaotic politics is just par for the course. The central point here is that given the pessimism about European growth, the hurdle for having a better outcome may well be a little over 1% growth for the year.

Emerging Markets

Emerging markets were hit with a plethora of challenges last year. Higher US interest rates and an ever-stronger dollar led to funding and liquidity challenges. At the same time, fears of slower global growth, emanating particularly from China and Europe, increased downside risks. Lower commodity prices were a further challenge. A full-blown trade war and the resulting reversal in global trade posed a potential nightmare threat. The resulting sum of these risk premia for all these challenges led to spectacular underperformance of this asset class last year. It also led to EM local debt being priced at an 18-year low as shown in Exhibit 1. Many of these headwinds are not only abating, however, they are reversing as well. Fed tightening is no longer in prospect. An ever-stronger dollar seems unlikely. Chinese growth could move from a headwind to a tailwind. And a much more sober approach to global trade resolution may be in the offing.


Exhibit 1: J.P. Morgan GBI-EM Global Div Price Index

Source: Bloomberg. As of 31 Dec 18. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Where to look for value

We believe the severe underperformance of spread sectors to global sovereign bonds last year presents a very meaningful opportunity. The expectation or fears of further slowing growth and further Fed tightening may both be misplaced. A meaningful diminution of trade tensions would be a further positive development. Clearly there are many sources of concern. We are particularly focused on protecting downside risks. The very low rate of global inflation is clearly a very serious yellow light with respect to global growth prospects. But the same dampened inflation strongly suggests we can lean on our expectation of very dovish monetary policy to use government duration as a complement to overweights in spread sectors.

The Federal Reserve System (Fed) is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.



Important Information


All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.