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The next market shock

There is a sense of unease in markets as investors try to anticipate what will be the next event to trigger market volatility.

Choppy price action and illiquidity have characterised fixed income markets over the past week and it has been interesting to witness how price correlation between assets has continued to break down in many instances. German Bund yields rose following hawkish sounding European Central Bank (ECB) commentary in the run up to next week’s meeting. Suggestions that an announcement on the taper of asset purchases may come at the June meeting have come as a relative surprise. However, the fact that this is a topic which is up for discussion should not be surprising at all and generally speaking we believe that it may be premature to start painting the ECB in too much of a hawkish light. Meanwhile, spreads in the eurozone periphery have remained very volatile and a hostage to price action in Italian government bonds (BTPs). There has been limited new news coming from Italy in the past week and we wouldn’t be surprised to see Italexit fears subside in coming days. Nevertheless, current spreads suggest an unstable equilibrium and if credit fears rise further, then ultimately this will call into question the prices of many other European assets.

US financial markets were relatively quiet by way of comparison. US equities have powered higher thanks to renewed strength in tech and following last week’s strong payrolls report and firm ISM data, it is noteworthy that the Atlanta Fed Nowcast of current quarter GDP stands at 4.5% (the highest reading this survey has seen in the last six years). Domestic strength has pushed US yields a little higher, with the yield curve flattening and 10-year notes holding close to 3%. Elsewhere though, price action has been very different with emerging markets (EM) coming under renewed pressure with Brazilian markets bearing the brunt of position capitulation as the trucker strike rumbles on. In Mexico, more hawkish NAFTA rhetoric and poll data favouring Andrés Manuel López Obrador continue to pressure markets, though a research trip to Argentina this week has made us feel more hopeful that the country is turning a bit of a corner with upcoming IMF support. We had been worried about ongoing reserve burn in Buenos Aires, though this seems to be slowing and unlike past episodes of crisis in the country in that policy makers now seem much more committed to doing the right things this time around.

It is almost tempting to want the Football World Cup to start, so that we can see some quiet summery markets for a time after a period which has been particularly turbulent.

Mark Dowding, Head of Developed Markets

 

In FX, the euro gained versus the dollar during the past week, supported by ECB comments with a number of large EM currencies remaining on the back foot. In this context, certain parts of the market might appear to be trading in a risk-on fashion – even as the flight to quality dominates price action in other areas. With respect to corporate credit, higher European yields saw insurance buyers putting cash to work with a bid for bonds supporting prices. With cash rates stuck in negative territory, it is hard for these sorts of investors to sit on cash for too long but with asset managers more wary of adding risk at this point, it was interesting to see significant dispersion in performance within the corporate credit universe. In particular, issuers with large volumes of debt outstanding seemed to meet solid demand from insurers, yet smaller, more niche issuers who are less commonly researched and are overlooked by much of this community seemed to attract very little interest. Meanwhile, financial issuers benefitted from higher Bund yields and a slight calming of volatility in the periphery, yet even as assets start to recover May losses, there is a real sense of nervousness running through markets at the current time and a sense that it is very difficult to project what will be the next event to trigger market volatility.

Looking ahead, it is almost tempting to want the Football World Cup to start, so that we can see some quiet summery markets for a time after a period which has been particularly turbulent. However, at the minute it still seems like there is a lot going on. Next week may be an important one with respect to Westminster as the Tory party continues to try to sort out its internal stance with respect to Brexit. Were Theresa May to lose votes next Tuesday, this could lead us towards a path in which a Leadership challenge could become likely. Moreover, if we are correct in our view that this months’ EU summit will pass without any further progress around Brexit, we sense that the temperature around negotiations will rise another notch as we head into the summer and we would continue to assert a bearish view on Gilts and the Pound in anticipation of volatility ahead.

We still expect next weeks’ ECB meeting to be more of a non-event and remain inclined to fade any significant rise in Bund yields at the current time. Meanwhile, in the US we favour a short duration stance and having closed this for now – partly as we were worried that EM wobbles could feed across into developed markets – we continue to look for opportunities on the short side and expect next Tuesdays likely move up in the consumer price index (CPI) to potentially add to the upward pressure on yields, ahead of the FOMC meeting later this month. As for geopolitics, amid the headlines about the on/off Korean summit between leaders, it seemed timely that it was another Kim (Kardashian) in the pictures winning concessions from the President in the Oval Office in the past week. Mind you, politics is anything but dull in this Twitter Age.