The change in liquidity conditions in global markets will drive asset prices this year. We saw a massive injection of liquidity from central banks and governments in 2020 to combat the adverse effects that Covid had on demand. That drove a strong rally in risk assets.
Now, both monetary and fiscal policies are being tightened. The US is approaching a fiscal cliff and the Federal Reserve (Fed) has eased purchasing of government bonds. A key result of this liquidity tightening is that risk assets are expected to weaken.
US bond yields have increased, especially in the front end, because of the Fed’s hawkish pivot from the middle of last year. The rhetoric from central banks in the developed world has become even more hawkish this year in response to very high inflation numbers. Although the numbers are expected to fall off from March due to statistical base effects, they are still expected to be high, and central banks are panicking.
What we are seeing now is a divergence in monetary policy between the developed world and emerging markets. Emerging markets have been raising rates quite aggressively in anticipation of Fed tightening. Brazil’s main policy rate now stands at 10.75%, compared to 2% in 2020, resulting in plateauing inflation. China’s Consumer Price Index-based inflation has begun to slow from its peak.
China cut rates last month, which stands in sharp contrast to the US, where several rate hikes are priced in the rates curve. There is a very high probability of a rare 50 basis points rate increase by the Fed in the next meeting. Chinese government bonds across the yield curve have been performing well over the past few years and offer attractive yield.
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