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Interest rates may have bottomed out. The disagreements that are starting to surface between central bankers over ultra-accommodative monetary policies and the slight macroeconomic improvement could spell the end to falling interest rates – provided the root problems do not deteriorate. Jean-François Gillardin, Head of Discretionary Portfolio Management, offers some explanations.
The US-China trade war and the difficult negotiations over Brexit have once again been the focus of market attention in recent months. These worries, combined with contained inflationary pressures and the slowdown in global growth, particularly evident in the manufacturing sector, persuaded the central banks to announce new quantitative easing measures.
After a cycle of very gradual interest rate increases, the Federal Reserve cut interest rates in July and September, for the first time since 2008. Similarly, in Europe, the ECB ended its September meeting with a downward revision of its deposit rate and the announcement of more specific measures.
These new measures and the ongoing uncertainties drove down government bond yields. At the beginning of September, the US 10-year Treasury yield hit a new low of 1.46% while the German Bund's 10-year yield fluctuated close to its all-time low of -0.71%. Even more telling is the fact that, at 1 September, all maturities on the German yield curve offered a negative yield. In other words, the German government receives money for borrowing, as investors are prepared to pay for the right to hold the country's debt. At that time, the bond market was anticipating a relatively gloomy macroeconomic scenario.
But since this low, yields have slightly rebounded on the back of positive news on the US-China trade talks and progress on Brexit. It remains to be seen whether this upturn is a simple rebound in a falling trend or if, on the contrary, it will continue in the months ahead. Two arguments support the second of these scenarios.
First, whereas the deceleration of global growth is clearly visible, the risk of recession in the United States appears limited for now. In this respect, we are closely watching the US consumer spending figures and activity in the services sector. This is because a substantial deterioration of these two variables – which are critical for growth – would strongly increase the probability of a recession.
For the time being, we are some way from that.
US consumer spending is showing no sign of running out of steam and is being shored up by a robust labour market, rising wages, and the increase in household net worth (the difference between households’ assets and liabilities). Meanwhile, services sector activity also remains buoyant although there are perceptible signs of a slowdown.
Also, on the whole, US macroeconomic data have tended to come in above market expectations in recent times. The recent rise in US bond yields even appears relatively limited given these good surprises.
Secondly, more and more voices are being heard on both sides of the Atlantic against ultra-accommodative monetary policies. Although investors seem to be unanimous in anticipating a cut in the Fed funds rate at its meeting on 30 October, they are considerably more divided over the likelihood of another rate cut in December. Fed committee members appear to be just as divided. For some of them, the recent interest rate cuts had a largely preventative aim given the prevailing uncertainties and were not based on any significant deterioration of the macroeconomic data. Consequently, it will be difficult for them to vote in favour of further interest rate cuts after the one expected in October.
In Europe, more and more central bankers, particularly in the north of Europe, are dubious about the positive impacts of this policy and are no longer afraid to publicly flag their disagreement. Any change of tone could therefore rapidly drive yields higher, even if few investors anticipate this scenario for the time being.
In view of the recent improvement in US macroeconomic data and the increasingly discordant voices coming from the central banks, we may be past the lowest point. Investors might do well to start to consider preparing for a gradual rise in yields by very slowly reducing their bond portfolio’s exposure to interest rate risk, especially if the trade war abates and progress on Brexit continues.