Going into the second half of 2017, economic and market prices are looking up. Trump’s reflation trade, which took off early November last year, did indeed take a tumble. Expectations of a whopping infrastructure plan, a full replacement of Obamacare and slashing corporate and personal tax rate, were quick to be dashed, spooking markets in the process.
However, since mid-April, risk-on has been the theme. So much so, that US 10yr yields have risen from 2.1% all the way up to 2.4%.
In the Eurozone
Before the French election result, spreads (French-German yields) had widened on the back of fears of a Le Pen victory and an expected increase in anti-euro rhetoric. Now with Macron at the helm, spreads have retraced significantly. Greece also saw its benchmark yield decline after a deal was reached between creditors.
With little or low inflation, bonds rally because central banks flood the system with cheap liquidity. This causes rates across the board to fall and prices to rocket. However, central banks globally are indeed pulling back. The Fed is looking to reverse the balance sheet, which would send yields higher. The ECB is looking to reverse their direction of travel in terms of the deposit rate and QE.
The Bank of England, one would assume, would look to raise rates as imported inflation takes hold of the UK economy. The only economies one would think that would be looking to be in stimulative mode and thus battling inflation would be the Australia and China.
One point to note is that it would not be surprising to see infrastructure plans being delayed if the Fed hikes aggressively. Assuming they go down the market route in raising funds for fiscal plans as opposed to infrastructure bonds, the interest cost would be higher for the government. Unless this was met with greater GDP growth, the debt burden would rise. Expect another can to be kicked down the road later this year.
In the US stock market, earnings growth has been good, and the fundamentals do look favourable. That said, if global rates rise, the discount rate applied to corporate cash flows would also go up, thus reducing the present value of company stock values, sending indices down, not to mention reducing consumer sentiment figures. The caveat to this is the speed of those rate rises.
The Fed up until now has given all the indications of allowing inflation to overshoot. If they were not keen on a hot economy, the US would already have a Fed funds rate of nearer 2%. This means the equity market will benefit from a higher growth trajectory while continuing to enjoy low discount rates.
In terms of euro debt markets, Italian spreads should compress if their credit rating remains above junk status. Fundamentals in Italy are good. The question from a bond investor’s perspective is not necessarily whether the economic fundamentals are fine in isolation, rather what would Italian yields blow out to if the ECB stopped operating as a major buyer. Are Italian rates artificial, or are they backed by positive investor views? Do the markets really believe the improving figures or will they begin to panic if another bank story is released later this year?
So given all this good news, is this trend likely to continue?
Time will tell, but certainly, the outlook looks decent. The canary in the coal mine was the French election, given the historical relationship between France and Germany. With the extreme tail risk to a large extent off the table, the markets will rightly focus on the improving fundamental backdrop. Beware the bond market for the rest of 2017.