Economic and market perspective
Tariffs and fears of protectionism remained in the headlines. Fears of a trade war with the European Union receded somewhat as President Trump and European Commission President Jean-Claude Juncker reached an agreement to forestall additional tariffs from going into effect. The European Union agreed to import more U.S. soybeans and liquid natural gas in exchange for the U.S. agreeing not to implement auto tariffs. The recently imposed U.S. tariffs on aluminum and steel remain in place subject to further negotiation.
At the same time, 25% tariffs on $34 billion of Chinese goods went into effect in early July. The Trump administration announced further 10% tariffs on an additional $200 billion of Chinese goods to go into effect in two months, with threats that the amount could increase to $500 billion. After a break in negotiations, the U.S. and China appeared to be resuming trade talks at the end of the month. The People’s Bank of China (PBOC) engaged in multiple actions to ease policy, partly in response to stresses from the trade dispute with the United States. In July, the PBOC unexpectedly injected over 500 billion yuan ($70 B+) into the Chinese economy with loans to financial institutions via its Medium-term Lending Facility loans and cut reserve requirements for the third time this year.
The Bank of Japan’s end of July meeting was widely anticipated on speculation of the first policy change since 2016. Japanese inflation data has remained persistently below target, with the last three months at only 0.2%. The BOJ left both interest rates and its quantitative easing program unchanged, but indicated it would loosen its yield curve control policy, allowing rates to rise more naturally on the margin. The Bank of England (BOE) is expected to increase interest rates on August 2nd. If this increase does occur, it would mark the second hike since shortly after the Brexit vote, when the BOE cut rates to 0.25%. The European Central Bank (ECB) met in July and, in line with expectations, made no changes to policy. However, the ECB did reaffirm the expectation of reducing and ultimately stopping monthly purchases this year. The ECB stated that they expect rates to “remain at their present levels at least through the summer of 2019.”
Minutes from the June 12-13 meeting of the Federal Open Market Committee were released in early July. In the minutes, the Committee expressed that the economy is “expanding at a solid rate” and the labor market is strengthening, but also that trade policy uncertainty could have a negative impact on the economy. While noting concerns that allowing inflation to run above trend could be damaging, which would suggest further rate hikes to stem inflation, some Committee members also raised concerns about the flattening of the yield curve. The market is not projecting a hike for the July 31/August 1 meeting, but projecting approximately a 90% chance of an additional hike at the September 25-26 meeting and a greater than 50% chance for a second additional hike before the year is over.
The U.S. Treasury Department raised its estimates for third quarter borrowing by $50 billion to $329 billion. With this projected increase, the Treasury expects to borrow $769 in the second half, the largest six month borrowing since the second half of 2008 when the Treasury borrowed $1.1 trillion. The Treasury is now projecting $1.33 trillion of borrowing for the full year.
Outlook and conclusions
During July, robust U.S. economic data combined with increased comfort in tariff policy noise led to lower volatility and retracement of interest rates to higher levels. This environment was broadly supportive of risk assets, including non-governmental fixed income. Our outlook for these sectors based on fundamentals remains positive, but we do not expect volatility to remain at bay. While continued normalization of U.S. monetary policy is broadly expected, we expect the pace of normalization within divergent global monetary policy and the unwinding of unconventional tools will prove significant to U.S. fixed income market developments. Additionally, with markets projecting two additional rate hikes in the U.S., the flattening of the yield curve will remain in focus for both the Fed and market participants. For now, as the economic backdrop remains strong, but policy uncertainty continues, both caution and optimism are warranted for fixed income investors.