This article was released on August 1, 2017. Find our latest U.S. fixed income insights here.
Economic and market perspective
Plans to repeal and replace ObamaCare dominated U.S. policy news in July. After multiple iterations, ultimately the effort failed in the U.S. Senate after a 49-51 vote against a “skinny repeal.” Pertaining to tax reform, Speaker of the House of Representatives Paul Ryan indicated that a border adjustment tax was no longer under consideration. This decision may ease upcoming debates around tax reform as the border adjustment tax had been one of the most contentious provisions of plans discussed to date. Trump administration members indicated that tax policy will be a significant focus with a target passing the House in October and Senate in November. Despite policy uncertainty, U.S. equity markets each set new highs during the month aided by several major companies announcing strong earning near the end of the month.
North Korea tested two intercontinental ballistic missiles (ICBM) during the month, prompting further sanctions of the country. The missiles are believed to be capable of reaching the United States, including major metropolitan areas. The most recent test led the U.S. to demonstrate its missile defense system as well as conduct fly-overs of the Korean peninsula in joint military exercises with Japan and South Korea.
After a 5% decline in June, Oil rose 9% in July, closing above the $50 a barrel level. This increase was partially driven by a decrease in U.S. output and declining U.S. inventories, but was offset by a report that OPEC (Organization of the Petroleum Exporting Countries) members had increased production despite an agreement to reduce output to manage prices. Prior to the increase in the oil price during the month, gasoline prices had hit their lowest level for the July 4th holiday since 2005 with a national average price of $2.23 a gallon.
The unemployment rate in Europe fell to its lowest level since 2009 at 9.1% for June. Overall inflation was unchanged at 1.3%, the lowest level of 2017. However, core inflation rose 0.1% to 1.3%, the highest level in four years. While the inflation outlook has improved, which gives the European Central Bank (ECB) greater policy leeway, the inflation level
remains well below the 2% target the ECB is seeking.
Outlook and conclusions
With improving economic conditions in Europe, expectations around a change in European Central Bank (ECB) policy are increasing. At the July meeting, policy remained unchanged with purchases of €60 billion per month continuing and a deposit rate of -0.4%. ECB president, Mario Draghi, indicated that the governing council had not yet discussed plans for the tapering off of purchases, but many expect an announcement to come this year and implementation to begin early next year. The Euro rose nearly 4% against the dollar in the month on expectations of monetary policy changes and improved economic data in Europe. The market is pricing in about a 50% chance of a rate hike by the ECB by next July.
The Federal Open Market Committee left the Federal Funds rate range unchanged in a range of 1.00% to 1.25% during their July 25-26th meeting. This result was highly anticipated and most observers were more focused on whether the Fed would tip their hand regarding the timeline for the previously announced changes in reinvestment policy related to assets maturing from the balance sheet. The Fed tweaked language regarding the time line for the wind-down from “this year” to “relatively soon,” though providing no specific initiation date. Fed Funds Futures imply nearly no chance of a rate hike at the Fed’s next meeting in September and about a 40% chance of an additional hike by the final meeting of the year in December.
In our view, even with slowing inflation, economic data in the U.S. has generally improved since the Fed first announced its plans to limit reinvestment of maturing balance sheet assets. The Fed has maintained a cautious, market friendly philosophy when reducing support and we expect that approach to continue. With healthcare reform derailed again, an administration pivot to focus on tax policy would be welcomed by the market and provide a tailwind to consumers and corporations. The current environment appears benign for U.S. fixed income even without tax policy changes, with a cautiously normalizing Fed having assuaged some of the concerns for Treasuries and mortgage backed securities. Improved second quarter GDP growth highlighted the strength of the consumer and business investment, furthering a strong corporate backdrop supportive of credit markets.