Central Banks: Try, Try Again

Mid Week Bond Update

Central Banks: Try, Try Again

Major bond markets aren't yet convinced that inflation will hit the mark.


Sovereign debt markets appear to be skeptical about the ability of major central banks to hit the 2% inflation mark. Five-year breakeven inflation rates, which offer a rolling verdict on consumer inflation five years hence, continue to fall short of that goal. That’s particularly notable in the case of the U.S., where a combination of fiscal stimulus and a return to accommodative policies on the part of the Fed has yet to deliver a sustained increase in inflation.
 

Major Economy Breakeven Inflation Rates Continue to Fall

Chart courtesy of Western Asset. Source: Bloomberg, as of 9/3/2019. 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.

According to Western Asset CIO Ken Leech, central banks themselves may be joining the doubters’ crowd, considering how to address inflation more directly, rather than expecting growth in gross domestic product (GDP) to carry the weight on its own. But given an apparent lack of unanimity within the Fed on the appropriate next steps, Leech sees the Fed moving slowly – but ultimately toward lower rates, given the uncertainty generated by the unpredictable path of global trade.

 

On the rise: Italian sovereign bonds

After the collapse of the governing coalition between the Five Star Movement and the League, the prospect of a prolonged search for a workable coalition to replace the last one drove Italian Treasury (BTP) prices down sharply, with yields reaching 1.803% on August 9, 2019 – a nearly 240 basis-point spread over Bunds. But the surprising compromise coalition between Five Star and the center-left Democratic Party (PD), a bastion of Italy’s establishment, brought BTPs well above their pre-collapse level, moving yields to 0.87% and pulled spreads in to as much as 157 bps over Bunds by September 3, 2019.

The surprising level of optimism over this yet-to-be-ratified deal between unlikely allies could be explained as Five Star valuing the PD’s relative consistency from a policy perspective, or as a political reassessment of its embrace of the right wing of its populist impulse. If a Five Star/PD coalition agreement is actually signed the coalition would have to survive long enough to make good on whatever promises its platform might entail, which given the unconventional matchup, is nearly impossible to handicap.

 

On the slide: U.S. manufacturing

The Institute for Supply Management’s monthly Purchasing Managers Index (PMI) for August 2019 came in at 49.1, well below the consensus forecast of 51.3 and below 50 for the first time since 2016. Because levels below 50 indicate contraction, this headline figure was cause for discomfort. But some underlying figures were also of concern – for example, the share of manufacturers reporting weakness in export orders shot up to 24 percent, the highest level since the latter part of the 2008-9 recession.

The figures don’t directly show the impact of the tariffs which went into place on September 1, 2019, though it’s possible that orders to be filled after that date could have been delayed as a tactic to avoid the inventory buildup that could result from the newest round of tariffs. It’s even possible that these figures reflect fear on the part of manufacturers rather than an actual business downturn, as pessimism pervades selling organizations as a result of the barrage of news about the escalation of trade conflicts. But since manufacturing accounts for less than 20% of the U.S. economy, the current downturn is likely to be a symptom rather than a cause of discontent.


All data Source: Bloomberg as of September 3, 2019, unless otherwise specified.

Definitions:

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.

An implied breakeven rate is a measure derived from comparing returns of two classes of securities whose value depends on the same factor, such as inflation or default rates.

The 5-year, 5-year forward breakeven inflation rate is a measure of expected inflation derived from "nominal" Treasury securities and their "real" counterparts—inflation-protected TIPS securities.

The Institute for Supply Management (ISM) is an association of purchasing and supply management professionals, which conducts regular surveys of its membership to determine industry trends.

The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction.

Buoni del Tesoro Poliennali (BTPs) are long-term Italian government bonds.

Bunds” refers to bonds issued by Germany's federal government. Bunds are available in 10- and 30-year maturities.

One basis point equals one one-hundredth of one percentage point.

A spread is the difference in yield between two different types of fixed income securities with similar maturities.

Buoni del Tesoro Poliennali (BTPs) are long-term Italian government bonds.

The Five Star Movement (Italian: Movimento 5 Stelle, or MSS) is a political party in Italy, founded on 4 October 2009 by Beppe Grillo, a comedian and blogger, and Gianroberto Casaleggio, a web strategist. The M5S is variously considered populist,anti-establishment, environmentalist, anti-globalist, and Eurosceptic. Its members stress that the M5S is not a party but a "movement", and it may not be included in the traditional left–right paradigm. The "five stars" are a reference to five key issues for the party: public water, sustainable transport, sustainable development, right to Internet access, and environmentalism. The party also advocates e-democracy, direct democracy, the principle of "zero-cost politics", degrowth and nonviolence.

Lega Nord (LN; English: Northern League) is a political party in Italy. In the run-up of the 2018 general election, the party was rebranded as Lega (League) without changing its official name in the party's statute. The party was nonetheless frequently referred to only as "Lega" even before the rebranding.

The LN was established in 1991 as a federation of six regional parties of northern and north-central Italy, and advocates the transformation of Italy into a federal state, fiscal federalism, regionalism and greater regional autonomy, especially for northern regions. The party has always opposed illegal immigration, especially when involving non-Europeans and Muslims. Under the leadership of Salvini, the party has redirected its focus on the latter issue. At the same time, the party began emphasizing Euroscepticism and other populist themes. Consequently, the party now forms a European alliance with right-wing populist parties such as France's National Rally, the Netherlands' Party for Freedom and the Freedom Party of Austria.  In the 2018 general election, the League was the third-largest party behind the Five Star Movement (M5S) and the Democratic Party (PD).

The Democratic Party (Italian: Partito Democratico, PD) is a social-democratic political party in Italy. The PD was founded on 14 October 2007 upon the merger of various centre-left parties including the social-democratic Democrats of the Left (DS), successors of the Italian Communist Party. The party's main ideological trends are social democracy and the Italian Christian leftist tradition. The PD has been also influenced by social liberalism which was already present in some of the founding components of the DS and DL and more generally by a Third Way progressivism. The PD was the second-largest party in Italy in the 2018 general election, the third-largest in the Chamber of Deputies and the fourth-largest in the Senate. 

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

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