Is the Fed really tightening?

Mid-Week Bond Update

Is the Fed really tightening?

Global bond markets soared on Wednesday, reversing a mixed five-day period, after US inflation disappointed for a third consecutive month and the Federal Reserve (Fed) reinforced its dovish stance, despite rising, as expected, rates. The US central bank lifted its target rate to 1.25%, from 1%. However, financial conditions continued to ease...

as weak US data partially offsets the effects of any rate hike (read more below). The US dollar plunged to its lowest level since May last year, and so did inflation expectations, which fell to their pre-US election level. Emerging Market (EM) currencies soared, with the Mexican peso breaking below the 18 units per US dollar for the first time since May last year, and more than wiping out its losses since president Trump was elected on Nov. 8. The currency has also been bolstered by an improving trade relationship between the two countries. Indian local sovereign bonds returned 1.6% over the past five trading days, the best in the asset class, after the central bank cut its inflation forecast and consumer prices gained 2.1% in May, below estimates.

EMs were also buoyed after the International Monetary Fund raised its Chinese economic forecast for this year to 6.7%, from 6.6%. China is a significant consumer of EM exports, including commodities. Oil fell to US$44 per barrel on continued oversupply challenges, although this time its drop didn’t drag down all currencies of oil-exporting countries, such as Canada and Mexico. The Canadian dollar was, in fact, the best performer against the greenback over the past five trading days, up 2%, after the central bank gave a rosier view of the economy and questioned the need for further monetary stimulus. European sovereign bond yields fell following dovish comments from the central bank and as Italy’s anti-euro Five Star party suffered a setback in the local elections. The British pound fell after Theresa May’s Conservative party failed to win a majority in the general election, forcing her to form alliances in order to form a government.

 

ON THE RISE

US Fed - tightening? What tightening? Despite Wednesday's rate hike, financial conditions have actually eased in the US, the opposite of what one might expect in a monetary tightening cycle. For a start, the benchmark 10-year bond yield, at 2.1%, is substantially below the 2.5% level it had on Dec. 1, before the Fed increased rates later that month, and also again in March this year. Secondly, equity prices have soared almost 10% so far this year – hardly a sign of tighter policy. Finally, the US dollar has dropped 4.4% since Dec. 1st, not quite the burden that US companies face when the currency is strong. This easing has happened as the global growth outlook has finally improved after a decade of practical stagnation, and also as a bit more leverage from banks has provided more liquidity to markets. Altogether, this has somewhat offset the effect of the recent Fed hikes and also raised questions about the appropriateness of the central bank’s planned hiking path. Click here to read the latest views of Western Asset’s Chief Investment Officer Ken Leech on the US economy and global markets.

 

The Fed vs the market: one tightens, one eases

Source: Bloomberg as of 14 June 2017. Fed is Federal Reserve. RHS is right hand side. Past performance is no guarantee of future results. Please find definitions in the disclaimer.

 

Italian bonds - Five star performance: Italian sovereign debt rallied 1.2% over the past five trading days, especially after anti-euro Five Star populist party suffered a set-back in last weekend’s local elections. The result removes political uncertainty in the country and increases confidence in the Eurozone, whose future had been challenged by Britain’s planned departure from the European Union and by the rise of anti-euro French candidate Le Pen, who in the end failed to win the country’s general election. Concerns overshadowing the Italian banking sector, given the still high level of non-performing loans, also eased after a new European banking rescue system was successfully activated last week: in Spain, Banco Santander bought the ailing Banco Popular for 1 euro, a move brokered by the European Central Bank and which didn’t involve any taxpayers’ money.

 

ON THE SLIDE

British pound – Inflexit hit: Sterling lost 1% against both the US dollar and the euro over the past five trading days, after prime minister Theresa May failed to win a majority in the country’s general election. The currency drop also came as a weaker Conservative-led government may have to apply a looser budget policy, especially after rival Labour party improved its results by promising more public spending. Sterling’s dip added to a string of poor economic data: Britain’s average wage growth slowed to 1.7% between February and April, below estimates of 2%, and also below the increased annualised inflation rate, which accelerated to 2.9% in May, the highest in four years. The increase, linked to a weaker pound, contrasts with the inflation slowdown in the Eurozone and the US, which, like most developed markets, face low energy prices and a still tight banking sector that may be preventing credit from flowing into the economy. Britain will start this month negotiating its departure from the European Union, a lengthy and complex process which may weigh on UK assets, according to Legg Mason portfolio managers. Read more.

 

Leader of the inflation pack: weak pound lifts UK prices

Source: Bloomberg as of 14 June 2017. The chart reflects annualised consumer inflation rates. Please find definitions in the disclaimer.

 

Russian ruble – rate cut hopes: The Russian ruble fell almost 1% against the US dollar over the past five trading days, partially due to the drop in the price of oil, a key country export. The relationship between the two, however, has been declining as foreign investors seem more interested in seizing Russia’s higher yields than on treating the country as an oil proxy. The yield of Russia’s 10-year, US dollar-denominated sovereign bond stands at 3.95%, well above the US’s 2.1% and Germany’s 0.2%. Bond investors have also been attracted by prospects of rate cuts: central bank governor Elvira Nabiullina has said that cuts of 25 and 50 basis points in the 9.25% benchmark are being considered, given the country’s improved inflation prospects. The Bank of Russia is scheduled to meet on Friday.

 

Source for all data: Bloomberg and Barclays Capital as of 14 June 2017, unless indicated.

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