Global Economic Perspective: July

US Bonds Caught Up in Global Trend of Falling Yields

June heralded a fresh downward leg in the pattern of falling US bond yields prevalent so far in 2016. Yields began moving lower early in the month following May’s disappointing US payroll report, and the move accelerated sharply following the unexpected decision by referendum voters in the United Kingdom to leave the EU. Even before the UK referendum result and the resulting spike in market volatility, the Fed had adopted a cautious tone. Subsequently, investors concluded there was a negligible chance US policy rates would be raised for some time to come, as the Fed remained on hold while assessing whether the US economy had been materially impacted. With market sentiment heavily favoring such views, a far stronger-than-expected payroll report for June had little impact initially on the Treasury market.

The record lows seen in Treasury yields signal to us how much the US bond market and indeed US monetary policy are being driven by international rather than domestic factors. Clearly, there are significant concerns about the global backdrop, but the Treasury market appears to bear little relation to the state of the US economy, where growth remains moderate but respectable, even allowing for any potential future downdraft from the UK referendum result. With yields on sovereign bonds in numerous countries now negative, Treasuries may stay attractive to investors on a relative basis despite being in unprecedented territory historically.

Minutes from the Fed’s June meeting underlined that policymakers were mindful of the potential risks to the US economy and global markets even before the UK referendum result. In the aftermath of the UK poll, Treasury yields fell to unprecedented levels, with the yield on the 10-year note reaching a new closing low of 1.36% in early July. In the fed funds futures market, expectations about the timing of the next US interest-rate rise were pushed back significantly, as far as the fourth quarter of 2018 at one point. Comments from Fed officials after the referendum result encompassed a variety of views, as some downplayed the potential for the aftershocks to have much effect on the US economy, and others pointed to a general tightening of financial conditions.

However, June’s strong payroll report did lead to a limited re-evaluation by investors about the shorter end of the Treasury curve. Following the data, fed funds futures moved to allow a higher possibility of an interest-rate rise before the end of this year, though an increase was still only seen as a 20% chance. Despite the headline monthly payroll number of 287,000 being well ahead of consensus expectations—leaving the three-month rolling average at 147,000—some other parts of the report were more equivocal, notably wage data, in which a monthly increase of 0.1% in average hourly earnings failed to meet expectations, though the annual increase did tick up to 2.6%. The pattern of subdued inflationary pressures was also in evidence in the Fed’s favored measure, the core personal consumer expenditures price index, which rose 0.2% month-on-month (m/m) and at an annual rate of 1.6%, with the equivalent headline numbers coming in at 0.2% and 0.9%.

A survey of chief financial officers (conducted before the UK referendum result) gave mixed messages about the US labor market, with around half reportedly planning to cut hiring or investment due to factors such as political uncertainty ahead of the US election in November. But many other survey respondents mentioned difficulties hiring skilled staff, hinting that wage pressures may soon rise. Elsewhere, other indicators underscored the resilience of the US economy, ahead of the as yet undetermined impact of the UK referendum result. Both of the Institute for Supply Management’s (ISM’s) purchasing managers’ indexes (PMIs) provided encouraging updates. The ISM’s index of services activity rose to a seven-month high of 56.5 in June, up from 52.9 in May and well ahead of consensus expectations. The corresponding index for manufacturing also beat forecasts, coming in at 53.2, as new orders and exports showed particular strength. Consumer spending remained robust, and retail sales posted another solid gain of 0.5% m/m in May, though slowing from April’s breakneck pace of 1.3% m/m. As a result, most predictions were for second-quarter GDP (gross domestic product) growth to show a marked pickup from its subdued showing during the first three months of this year, with the Atlanta Fed’s GDPNow forecast tracking at 2.4% as of July 6.

Regardless of the US economy’s strong underpinnings, our sense is neither the Fed nor most market participants are focusing primarily on domestic fundamentals, but instead on the wider and weaker global backdrop. Fixed income markets generally look to be in thrall to the expansive monetary policies of the Fed and other major central banks, and it seems likely US interest rates will remain lower for longer than we had previously anticipated. As the uncertainty engendered by the UK referendum result continues to cast a shadow over parts of the global economy—one that might lengthen if, for example, there were more adverse political surprises—investors will probably keep on seeking out US bonds as a relatively higher-yielding place to put their money.

Effect of UK Poll Result on Global Economy Unclear

The shock of the UK referendum decision and the resulting extremes in bond market pricing across the world were in some ways suggestive of past systemic episodes, such as the 2012 eurozone crisis and the global financial crisis of 2007–2008. Yet although fixed income investors appeared swift to conclude a significant weakening of global economic growth was all but assured, other markets were less reactive, with signs of stress relatively hard to find. Indeed, following the release of the strong US payroll number for June, the S&P 500 rallied to close near a record high, leading to the unusual scenario of simultaneous strength in bond and equity markets.

Currencies, however, did reflect the scramble by investors for perceived havens, and the US dollar rallied sharply following the UK result, eradicating its previous losses in the second quarter on a trade-weighted basis. The Japanese yen remained the haven of choice for many, building on its strong showing so far in 2016 and moving close to the ¥100 level against the US dollar. In an indication of the potential for contagion, Mexico’s central bank was forced to raise interest rates to defend the Mexican peso—the most liquid and widely traded emerging-market currency—which had weakened as investors fled emerging-market assets in the immediate aftermath of the UK poll.

But in general, riskier asset classes, including those in emerging markets, held up well after an early markdown. An initial spike in risk aversion among investors gave way to a renewed search for performance potential, once it became clear markets had coped with the shock of the UK result and sovereign bond yields were heading even lower. Corporate bonds saw strong inflows, and the dwindling prospect of a rise in US interest rates supported emerging-market assets, as they are seen as likely beneficiaries from capital flows if global monetary policy stays loose. Oil prices at first showed little reaction to the UK vote, remaining close to the US$50 per barrel mark, but they started to lose ground in early July as supply disruptions eased, with figures showing production from OPEC (Organization of the Petroleum Exporting Countries) reaching an eight-year high in June.

Assessing the way forward is now even more challenging, since the political and economic uncertainty created by the UK referendum result has further obscured the global outlook, although clearly there are few obstacles in the way of lower interest rates. Central banks in many parts of the world were already committed to substantial monetary easing to combat deflationary forces, and those that were not—such as the Fed—now have little incentive to swim against the tide. The forces of populism that have been unleashed since the global financial crisis show little sign of diminishing, raising the possibility of further rejections of the market-friendly orthodoxies of globalization through the ballot box.

Nevertheless, we would question whether the extraordinary valuation metrics currently found across bond markets—with, for example, both the German and Japanese yield curves largely negative—are justified by the possible outcomes for the global economy. In the aftershock of the United Kingdom’s decision to leave the EU, such valuations seem more driven by a cyclical crisis of confidence—which, in our opinion, should recover at some stage as the most extreme outcomes become less probable—rather than signs of a significant deterioration of fundamentals.

UK Poll Result Likely to Create Prolonged Uncertainty Across Europe

The decision by UK voters to leave the EU triggered a sharp reaction in European markets, most notably in the country where the referendum took place. UK Gilt yields quickly moved to historic lows, amid widespread predictions that prolonged uncertainty about the timing and manner of the United Kingdom’s eventual exit from the EU would push the country into recession. The British pound fell sharply, slumping to its lowest level against the US dollar in more than 30 years. In an echo of the global financial crisis of 2007–2008, several UK real estate investment funds suspended trading after a wave of redemptions by investors.

But the effects were by no means confined to the United Kingdom, as the prospect of political impasse threatened to significantly undermine confidence across Europe, and particularly within the eurozone. German Bunds were in such demand 10-year Bund yields turned negative and by early July had approached -0.20%. Yields on equivalent-maturity bonds issued by Denmark and the Netherlands also moved into negative territory, while the Swiss government bond market, another area seen by investors as a safe haven, became negative-yielding across all maturities. The UK referendum result led to renewed doubts about the stability of the rest of the EU, and consequently spreads between the debt of most non-core eurozone countries and German Bunds widened, although the general downward pressure on yields lessened the impact of such moves.

However, the state of bond markets did contribute to a widespread selloff of European banking shares in the aftermath of the UK vote, as the drop in interest rates threatened to further undermine banking profits. The falls were greatest among Italian banks, many of which have been struggling under a heavy load of unprovisioned bad loans, a weakness that seemed likely to be highlighted by ECB stress test results due to be released in coming weeks. The deteriorating sentiment surrounding the Italian banking sector increased tension between the Italian government and the EU, with the latter authorizing some government measures to assist the short-term liquidity of Italian banks, but firmly resisting any more comprehensive state assistance that might undermine the EU’s new rules aimed at forcing creditors to bear the brunt of rescuing troubled banks.

The UK referendum’s shock result also had the effect of increasing the focus on Italy’s forthcoming plebiscite, which is due to take place in October. Italian Prime Minister Matteo Renzi called the poll to gain approval for proposed constitutional reforms and has staked his political reputation on a successful outcome, but after UK voters delivered such a bloody nose to their government, speculation grew about whether another such populist upset could occur in Italy.

With the UK economy struggling to adjust to the changed political and economic landscape, the BOE was active, making reassuring noises on monetary policy and UK banking liquidity. The ECB kept a lower profile, since the market stresses in the immediate aftermath of the UK result were less striking than many participants had expected. European equity markets sold off but then stabilized fairly quickly, while the euro had a modest fall against the US dollar. The ECB’s recently started purchasing program and the sharp drop in sovereign yields provided support for euro-denominated corporate bonds, though the UK corporate bond market fared less well.

In terms of monetary policy, we had expected the BOE to move into easing mode, though it chose not to do so at its July meeting, but we think the ECB will try to gauge the impact of the UK result, rather than rush to expand or extend its current program of bond purchases.

Regarding negotiations between the United Kingdom and the EU, they could be extended and painstaking, given the stakes for each party, and both sides seem likely to stick to their entrenched positions. The United Kingdom will probably be reluctant to be forced into an accelerated path to exit the EU, with all the constitutional issues such a move potentially raises, and the EU authorities could take a tough line to discourage other member states that might be questioning their own future within the union, with the additional complications of French and German elections looming in 2017. However, the longer the UK’s position remains unresolved, the greater the negative impact on both parties could be.

The comments, opinions and analyses presented here are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

What Are the Risks?

All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

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