The calm before the storm
Investors appear to be retreating from their earlier fears regarding Italy, the European Union, trade war, and emerging markets. Nothing, however, has structurally changed and we expect volatility to re-emerge.
Fixed Income Specialist, Saxo Bank
This week, even the land of Vikings has seen the so-much-anticipated 30 degrees Celsius. And it is when the majority of your colleagues are out of the office and the remaining ones are daring to come to work wearing flip flops that you come to the conclusion that summer is finally here.
Although many of you may be more concerned about tanning or building the perfect sandcastle on the beach, in the background, financial markets will continue humming away and will not be affected by the summer heatwave.
While it is fair not to expect much volatility during the next few weeks as many are away, central banks and politicians continue with their agendas and if we are not careful to assimilate news as it comes out, it will be more difficult for us to get back to work once we return. This is why in this article I will touch upon the most relevant things to watch out for this summer, so that while you are relaxing under the sun your brain will still have food for thought.
Central banks policies from easing to tightening
With rumors that the Bank of Japan is to change its policy at the end of the month, investors are starting to realise that central bank monetary policies worldwide will continue to be one of the biggest theme for the rest of this year and the next.
Across the Atlantic Ocean, pressure to tighten the economy is clear as the chairman of the Fed, Jerome Powell, continues to be bullish on growth and fears that inflation will get out of control. This year the Fed hiked interest rates twice and it is expected to hike twice again before year end. If this is the case, this will put upwards pressure on the front end of the yield curve, causing yields in the short part of the curve to rise faster than the yields in the long part of the curve.
Central bank policies have already weighted a lot on USD bond performance this year, as a matter of fact we started 2018 with the 2-year Treasury bill yield at 1.87% yield and now it is trading +75bps wider at 2.62%. At the same time the yield on 10-year Treasuries moved up only by 50bps, resulting in an overall flattening of the US yield curve.
Although the European Central Bank and the BoJ are yet not in tightening mode, they already started to taper their purchases, meaning that overall there is less and less money in the global financial system compared to the past ten years. If the trend of central banks to taper and gradually move towards tightening continues, we can expect bond prices to lack support, causing episodes of volatility in the fixed income space, especially the emerging markets.
This is why it is important not to lose sight of central bank monetary policies, especially now that the market has become increasingly sensitive and a change of policy by the BoJ might mean that there would be a considerable repricing of sovereigns worldwide.
Watch out for the following dates: The European Central Bank will meet on July 26, the Bank of Japan on August 31 and the FOMC is to meet on August 1.
US yield curve flattening leaning towards inversion
Concerns regarding a Fed overtightening brings us back to the financial market’s biggest fear: a possible inversion of the US yield curve which could predict the coming of a recession. In the past, recessions have been preceded by an inverted yield curve and now that the spread between 10-year and 2-year Treasuries is around +30bps, the market is growing more and more cautious. As we have outlined in Saxo Bank’s Q3 Outlook, we believe that an inversion of the yield curve will be likely by the end of this year and the beginning of the next, however, a recession might not happen until the second half of 2019. This is a key topic for bondholders to monitor and while we believe that an inversion of the yield curve is a negative sign, opportunities can arise, especially in the short part of the curve.
It is important to note, however, that central bank policies worldwide heavily weight on the direction of the US yield curve. A change of policy by the BoJ might cause the US yield curve to steepen as liquidity in the long part of the curve would diminish.
The market rightly fears an escalation of an unnecessary trade war with US trade partners such as Canada, Mexico, China and the European Union, and it is news regarding this topic that can dramatically change the performance of our portfolio.
However, from a fixed income point of view a bigger issue may be getting started: the growing attention that the president of the USA is giving to Fed policies. As a matter of fact, he recently commented negatively on the Fed decision to raise rates and although the president doesn’t have any power over monetary policy, his comments may still provoke volatility in this space.
Watch out: today for the meeting between Trump and the EU's Juncker where tariffs are going to be discussed.
Leaving central banks policies and Trump aside, the two biggest risks that we are facing in Europe concern news coming out of Italy and the United Kingdom (click here for our our recent article on the increasingly tortuous Brexit saga).
Although in the Mediterranean country summer has arrived, it is important to note that the newly formed Italian government is already turning its attention to its spending plan. On one side, the Northern League wants to introduce a flat tax rate of 20% and 30% for both companies and individuals, and on the other side the five-star party is looking to increase benefit spending and to establish income support for low-income citizens. These policies are in contrast with European budgetary rules as an increase in spending would mean that Italian deficits would shoot above EU restrictions. Deputy premier Matteo Salvini seems to be getting ready to get into a fight with the EU as on Monday he told reporters that “for the good of Italians” he will not hesitate to surpass the limits set by the EU.
We believe that as we are getting closer to the presentation of the 2019 budget in Autumn volatility in Italian sovereigns and corporates will resume and short term maturities and subordinated bonds of domestic financial institution will most likely be affected.