The Federal Reserve meeting passes with little drama while policy and politics continue to engulf Europe
This week’s Federal Reserve meeting was something of a damp squib, which was a bit of a disappointment to us. Although the Federal Open Market Committee (FOMC) statement made a modest upgrade, there was little to point to a March rate hike in the rest of the text. However, with this weeks’ data highlighting potential upside risks to growth and inflation (with the prices paid component in the ISM survey at a six year high), we believe that a Q1 tightening cannot be ruled out if these trends persist over the next two months. We will see the monthly payrolls report later today, but would note that the view we have formed is that the labour market strengthened in the wake of the Presidential elections and with jobless claims data and the ADP survey appearing to confirm this, we see risks to this data release clearly skewed to the upside. Moreover, we have been making the point that, in adopting a short rates position at the front of the US curve, any losses in this position if our views do not manifest should be relatively modest, with less than two hikes priced for 2017 as things currently stand.
European inflation data generated a number of headlines earlier in the week, with eurozone consumer price index (CPI) rising more than expected to +1.8% yoy. An overshoot of the European Central Bank (ECB) inflation target is now likely in the next few months and although core prices remain more subdued, firmer data across the continent points to a cyclical upswing in activity, suggesting that the ECB will come under pressure to announce a taper of its QE purchases in the months ahead. As this becomes more evident, this is putting upward pressure on European bond yields, though German Bunds have been outperforming on a relative basis. As the free float of Bunds declines, so the ECB will be purchasing a larger percentage of that free float in 2017 than 2016, meaning that the relative scarcity of Bunds can only increase. With the yield curve already very steep due to ultra-low rates at the front end of the curve and with the ECB unlikely to hike the repo rate before the end of 2018, the carry and roll effect is also helping to anchor Bunds, whereas other eurozone sovereigns are impacted by a seemingly more negative supply/demand balance.
In Italy, spreads versus Bunds have reached three year wides, with investors showing little interest in recent new Italian government bond (BTP) issues. Historically Italy has benefitted from large domestic savings, which have supported a large domestic government bond market but with Italian retail investors shifting their savings towards more global strategies and alternative asset classes, at a time when 10-year BTPs still only yield 2.2%, it is less clear who will be the marginal buyer of Italian debt once the ECB steps back. In this context, it seems more of a bad technical dynamic driving a re-pricing of Italian spreads than any immediate concern related to Italian political risk.
By contrast, developments in France have seen political worries accumulate, following a sharp slump in popularity from the Republican front-runner, Francois Fillon, following allegations of financial impropriety related to payments made to his family members. Fillon’s descent has seen Emmanuel Macron’s popularity continue to rise, yet we have seen how candidates can come and go relatively quickly and a lead at this stage of the race is no guarantee of victory. Indeed it won’t be shocking to see more skeletons coming out of the closet in the weeks to come and so the race for the Elysee remains relatively wide open. In this context, we have thought that, if the probability of Marine Le Pen winning is put objectively at 20%, and her election would push spreads on French government bonds (OATs) 200bps wider, then it is fair to think that a widening of 40bps is a fair pricing of the political risk premium, ahead of the election. We have maintained a short position in OATs since late last year on the assumption that the Bund-OAT spread would consequently push towards 70bps at the 10-year point of the curve and as it has done so, we are now closer to a level where we are starting to book profits on this short.
Indeed it won’t be shocking to see more skeletons coming out of the closet in the weeks to come and so the race for the Elysee remains relatively wide open.
Elsewhere this week, we have seen the UK Parliament push through a vote allowing Theresa May to enact Article 50 and begin the formal Brexit process. We would concur with Bank of England Governor Mark Carney that the fallout from last summer’s referendum has only just begun and having witnessed an initial Brexit honeymoon helped by a cheap British pound and policy stimulus, we are now moving to a point where business investment is shrinking and consumer spending is restrained as prices more rapidly than incomes.
Looking ahead, we believe that the US jobs report today promises to be particularly important. However, looking beyond this we continue to be bombarded by an array of tweets and headlines as we continue to adjust to the new modus operandi of the Trump White House. Uncertainty remains elevated and notwithstanding the selection of Neil Gorsuch to the Supreme Court, we are yet to see any more detail related to budgetary plans, or trade. The erratic side of Trump was also shown in his putting the phone down half way through a call with the Australian premier when discussing a prior agreement relating to the resettlement of refugees. Yet, the dichotomy of perceptions we highlighted last week continues to strike us and it was interesting to see a Rasmussen Report this week, suggesting that the percentage of US citizens thinking that the country is heading in the right direction has risen to a 12 year high, with a majority also seeming to support the recent travel ban - all very much at odds with the tone of protests coming from European capitals. Notwithstanding this, there may be a sense that financial markets are now getting a bit bored with the daily tweets and it is becoming realised that it is the Bills that pass through the Senate and Congress, which will ultimately matter more than some of the Executive Orders – many of which seemed more framed towards the reality TV audience.
On this note, it is interesting to hear reports that Wilbur Ross will be representing the US in the North American Free Trade Agreement (NAFTA) renegotiation talks. This may be a sign that away from the noise and the bluster, more substantive issues will pass into the hands of more responsible CEO types within the administration. Interestingly, away from Trump’s remarks relating to ‘The Wall’ and ‘Bad Hombres’ in recent days, the Mexican peso has slowly and quietly been recovering its earlier losses.
As we move into the Chinese year of the Rooster, it’s nice to see The Donald getting into the spirit of things by the looks of his hairstyle boarding (H)Air Force One earlier this week. Hopefully, this can be a period of peace and prosperity – after all, 2018 is going to be a Dog.
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