SUMMARY

  • The political landscape continued to surprise. The British snap election backfired on Prime Minister Theresa May as her party lost its majority. France’s Emmanuel Macron fared much better in parliamentary elections while political turmoil continued in the U.S. and Brazil.
  • A host of central banks showed signs of reducing accommodative policies that have been prevalent for years. The Fed raised rates for the third time in six months while comments from the ECB, BOE and BOC were all interpreted as hawkish.
  • The hawkish shift in tone from central banks drove interest rates higher and yield curves flatter while oil prices slumped into a bear market. A late-month sell-off in bonds followed central bank comments that hinted at less accommodative policy. Meanwhile, crude oil prices fell nearly 5% on supply dynamics, and the U.S. dollar fell against most developed market counterparts.

In the world

The political landscape continued to surprise. British Prime Minister Theresa May’s snap election backfired when her party lost its majority in parliament in June, throwing the government into a state of uncertainty and undermining her negotiating position heading into Brexit talks. Emmanuel Macron, on the other hand, fared better in France’s parliamentary elections, unexpectedly securing a majority that should help him push through much-needed labor law reforms. The Saudi royal family even saw a shakeup as King Salman named his 31-year-old son, Mohammed bin Salman, next in line to the throne at the expense of his nephew. This shift, however, was largely expected as the new crown prince was already responsible for oil policy, defense and the economy, including the recent decision to cut ties with neighboring Qatar over the country’s friendly relationship with Iran. Paralysis continued to grip Washington: The healthcare bill was pulled (again) from the floor in the Senate as Majority Leader Mitch McConnell struggled to wrangle enough votes before the July recess. The Trump-Russia probe also cast a pall over the administration, and FBI director James Comey’s testimony before the Senate Intelligence Committee dominated the news circuit. Lastly, in the latest blow to the country’s political stability, Brazilian President Michel Temer was charged with taking multimillion-dollar bribes and will proceed to trial if two-thirds of the lower house approve.

A host of central banks, including the Fed, ECB, BOE and BOC, showed signs of reducing monetary accommodation that has been heavily prescribed since the financial crisis. With economic growth on sound footing, Federal Reserve officials raised the policy rate above 1% – the third increase in six months – and officially provided some details on how the Fed will shrink its $4.5 trillion balance sheet; the Fed plans to gradually end reinvestments from maturing Treasuries and mortgage-backed securities starting sometime this year. While front-end Treasury yields drifted higher, this was quickly overshadowed by rate moves in Europe, where markets took ECB President Draghi’s comments on a strengthening recovery as hints that the ECB may soon trim its bond-buying program. The comments came amid sturdier eurozone manufacturing and multiyear highs in business and consumer confidence. In the UK, year-over-year inflation of 2.9% prompted BOE governor Mark Carney and three voting members to suggest rate hikes may soon be appropriate; the pound jumped and rates moved sharply higher.

The hawkish shift in tone from central banks drove interest rates higher and yield curves flatter, while oil prices slumped into a bear market. Though the 10-year U.S. Treasury yield touched 2.10% during the month – the lowest level since November 2016 – the shift in tone from key central bankers sparked a late-month sell-off in bonds that quickly spread across the globe. While front-end yields rose across developed markets (DM), a tepid near-term outlook for inflation kept a lid on longer-dated rates. Oil prices tumbled as lingering fears of oversupply underscored skepticism of the OPEC deal to stabilize prices and the U.S. dollar slipped for the fourth month in a row against a basket of DM currencies. Despite rising DM rates and falling commodity prices, emerging markets (EM) were broadly stable, and both local currency debt and equities gained on the month. Chinese markets were in the spotlight as global index provider MSCI elected to include local A-class shares in its benchmark emerging market equity indices for the first time, a milestone symbolizing the integration of China’s equities with the global markets.

Opportunistic Tightening
The Fed raised interest rates for the third time since December 2016 and announced plans to start unwinding its balance sheet later this year. Yet, financial conditions have actually eased since the start of the year, owing in part to lower Treasury yields, higher equity prices and a weaker U.S. dollar. While that may seem counterintuitive, the Fed’s current hiking cycle has more to do with getting away from the dreaded zero-bound than it does with a traditional “tightening” of conditions to slow an overheating economy. Thus, the Fed is taking the opportunity to gain room to maneuver without upsetting solid (if lackluster) growth.

In the markets


Emerging Markets’ Resilience
Driven by export linkages, emerging market (EM) bonds and commodity prices – particularly crude oil – have historically exhibited a high correlation with one another. However, returns have decoupled quite dramatically thus far in 2017: EM local bonds have gained 10% while Brent crude oil prices are nearly $9 per barrel (or about 16%) lower. The breakdown in the traditional relationship between EM and oil prices has a few potential explanations. First, oil price softness has been driven by a supply overhang while global demand has remained robust. Second, the drop in oil prices has coincided with a weaker U.S. dollar and stronger local currencies, attracting capital flows into EM. Last, EM fundamentals appear encouraging and diminished inflationary pressures are allowing EM central banks to ease policies and stimulate growth.