Asset Class: U.S. Fixed Income

June 2018 Fixed Income Market Update

Economic and market perspective

Political developments in Italy triggered broader market concerns in late May. Populists parties won Italian elections in March, but after forming a government their candidate for finance minister was vetoed by Italy’s president in May. As a result, the populist coalition appeared to withdraw from forming a government, setting up the need for new elections. Market concerns center on the potential results of those future elections, with many expecting the populist parties to benefit from the perception that the E.U. is having too large an influence in Italian politics. The prospect of a larger victory for the populist parties raised market concerns about an Italian departure from the Eurozone, however as the month ended the populist parties appeared to reach a compromise to form a government.

Treasury secretary Steve Mnuchin said in mid-May that the U.S. and China were “putting the trade war on hold,” reflecting what had already seemed like waning tensions in the ongoing tariff spat between the two countries. The Trump administration is seeking a $200 billion reduction in the U.S. trade deficit with China. Though both sides claimed progress in trade negotiations, at the end of May the Trump administration said its plan to implement tariffs were moving forward with a final list of tariffs being released mid-June and going into effect shortly thereafter. Also at the end of the month, Commerce Secretary Wilbur Ross announced that waivers for E.U., Canada and Mexico would not be renewed and steel and aluminum imports would be subject to tariffs effective at month end. The E.U. is widely expected to issue retaliatory measures.

While external vulnerabilities of emerging market sovereigns are generally thought to have declined, the impacts of higher U.S. rates and an appreciating dollar had impacts on emerging markets during the month. Major emerging market countries such as Argentina and Turkey experienced significant currency depreciation in May. Argentina is negotiating a bailout package with the International Monetary Fund (IMF) expected to be in the range of $30 billion. Managing Director of the IMF, Christine Lagarde, stated that the package will “protect growth, job creation, and social cohesion” in contrast to the Argentinian perception of the negative impacts of the last IMF package.

President Trump announced the United States’ withdrawal from the Iran deal (Joint Comprehensive Plan of Action) on May 9. The withdrawal frees the U.S. to re-impose sanctions on Iran, which President Trump announced will occur near-term. Combined with dollar strength and continued global growth, the U.S. exit from the Iran deal helped oil rise as much as 5% intra-month, exceeding $70 a barrel for the first time November 2014. However, by the end of the month Eurozone turmoil and expectations that a June OPEC meeting could result in increased production led to oil giving up its monthly gains.

At the May 1-2 meeting of Federal Open Market Committee, the FOMC left the Fed Funds rate unchanged at 1.5-1.75% in line with market expectations. The Fed statement included the view that “inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term” and that economic conditions “will warrant further gradual increases” in the Fed Funds rate.

Minutes from the May 1-2 meeting were released on May 23. In the minutes, the Fed repeatedly referred to the 2% inflation target as ‘symmetric’ and indicated that the FOMC would be comfortable with a temporary period with inflation above the 2% target. The minutes also indicated that “it would likely soon be appropriate for the Committee to take another step in removing policy accommodation,” which has been broadly interpreted as suggesting a June rate hike. The market is projecting a near certainty of a rate hike at the Fed’s June 12-13 meeting and approximately a 70% chance of an additional hike at the September 25-26 meeting. Also in May, the Fed proposed loosening certain aspects of the Volker Rule with the goal of replacing “overly complex and inefficient requirements with a more streamlined set of requirements.”

 

Outlook and conclusions

In our view, May neatly captured the vacillation of bond markets between positive economic data driving rates higher and geopolitical risks and policy concerns pulling them lower. This tug-of-war was seen as the 10-year Treasury yield rose to its highest yields since 2011 mid-month before rates declined back below 3% by the end of the month. Whether emanating from Italian populism and fears of impact to the Eurozone or uncertainties around international trade policy, U.S. fixed income and Treasuries, in particular, remain a safe haven asset. At the same time, credit spread widening given these increasing tensions has allowed spreads to return closer to historical median levels, but set against a strong fundamental economic backdrop, the combination of which offers better prospects for investors in the space.

 

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