US RATE HIKE IN JUNE LOOKS MORE PROBABLE
The tone of the latest policy meeting minutes, published on 18 May, was more hawkish than expected. Improved financial market conditions brightened the outlook for the US economy. FOMC policymakers were also reassured by further improvements in labour market conditions. Risks posed by global economic and financial developments were generally seen as having receded.
Given these brighter prospects in tandem with energy prices having bottomed out, policymakers expected inflation to rise to the Fed’s 2% inflation objective in the medium term. Since the other policy objective – low unemployment – was also coming into sight, they felt encouraged to leave open the possibility of a rate rise as soon as June. In fact, the bar for further tightening was lowered.
There was even some concern among policymakers that market participants had not properly assessed the likelihood of a June hike and that communication to this extent was needed. It came: several Fed officials said rates could rise soon and that two rate increases were possible this year.
But what about the UK referendum on EU membership which will be held soon after June’s FOMC meeting? Some policymakers noted that global financial markets could be sensitive to a pro-Brexit result, but they did not give the impression that Fed policy would be on hold just for that.
In sum, the market-implied probability of a June rate rise has skyrocketed. After hawkish comments by Fed officials, it rose from 4% to 12% and after the release of the latest FOMC minutes, it jumped to 32%. The probability of a hike in July is now above 50%, according to the pricing of fed funds futures. All eyes will now be on Fed chair Yellen who is scheduled to speak on 27 May.
MARKETS DIGEST THE UPCOMING US RATE RISE
Financial markets were mixed about the increased likelihood, but there were no major shocks. In fact, the US yield curve has flattened since the Fed’s rate rise in December. This could imply that bond markets see a risk of a policy error and are not convinced that the Fed has started on a hiking cycle. But let’s not forget that quantitative easing in the eurozone and Japan is capping 10-year yields.
The US dollar strengthened somewhat. Equity markets slipped, but recovered quickly. And when the latest new home sales data showed a surge in sales and prices, US equity markets jumped. Banks led the rally on the prospect of higher interest-rate margins and a resilient housing market. Equity markets and banks in particular also did well in Europe, possibly supported by news that the Italian government would accept stock as interest on financial aid for the troubled banking sector.
GREEK DEBT RELIEF? GETTING THERE…
Greece and its creditors reached a deal which paves the way for the release of another EUR 7.5 billion in aid out of its current EUR 86 billion rescue programme, but the real news was that debt relief is now possible in principle. In a major concession, the IMF agreed that the debt-relief measures will come at the end of the programme and not now, which the fund had insisted on previously. This will postpone any such negotiations until after next year’s German elections. Importantly, the IMF has stayed on board and the Greek debt is off the risk radar again for a while.
THE MANUFACTURING WEAK SPOT
Manufacturing remains the soft spot in the global economy. Regional measures of US producer confidence have disappointed and the national Markit purchasing managers index (PMI) for the manufacturing sector has slipped to its lowest level since September 2009. The economy still looks to be in an inventory-adjustment cycle and exporters are wrestling with a stronger US dollar. In Japan, the manufacturing sector has also recently had to cope with a strengthening currency.
In France and Germany, the manufacturing PMI rose, but PMIs have fallen in other large member states. Compared with the average of recent years, the euro is still cheap versus the dollar, but the beneficial impact of the depreciation should be fading. Moreover, on a trade-weighted basis, the euro is relatively strong, partly due to the weakness in the British pound.
ASSET ALLOCATION: DURATION EXPOSURE SHIFTED FROM EUROZONE TO US
In government bonds, we moved some of our exposure to the US. We expect longer-term returns in the US to be higher. The risk that yields will rise is probably greater in the US than in Germany since the Fed seems willing to raise interest rates, even if markets are more sceptical, while the ECB’s asset purchase programme should continue to cap yields in Germany. But even if yields in the US rise somewhat, we think the carry and the roll-down will compensate for that.
One reason to move away from a broad eurozone bond exposure is that there is a risk that spreads on ‘peripheral’ government bonds will widen. Spreads on Spanish and Italian debt are relatively low, but both countries are struggling to cut government deficits and debt. The outcome of elections in Spain is uncertain, while in Italy, a referendum on constitutional reform is a market risk.
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