Bond Yields Fly Again

Hawkish Commentary Sees Bond Yields Fly Again

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Central bank commentary has been driving headlines throughout the second quarter, from our perspective, and last week was no exception as several monetary policymakers in different jurisdictions gave a hawkish tilt to speeches, fuelling speculation that the period of ultra-accommodative monetary policy could be approaching an end.

On Tuesday, European Central Bank (ECB) President Mario Draghi revealed his optimistic thinking across the board on growth, inflation and the impact of monetary policy. His comments were seen as consistent with a start to tapering early next year. At the same time, however, his remarks were not prescriptive, which allows the central bank to retain flexibility in both the nature and pace of any potential tapering.

Draghi pointed to a broadening recovery, which he said has become more consistent across the eurozone. He also made it clear that he felt the role of monetary policy had played an important part in the growth story.

On the other hand, while Draghi suggested that inflation forces were now replacing deflationary headwinds, he stressed that a considerable degree of accommodation would still be necessary to put inflation on self-sustained footing. There were also concerns regarding the potential for market volatility to trigger an unwanted tightening of conditions.

Despite these caveats, Draghi’s more hawkish slant was the main takeaway, which was reflected by a sharp move higher in European government bond yields. The German 10-year bund yield reached its highest level since Marchand the he euro reached levels not seen since June 2016. The moves in the bond and foreign exchange markets led to ECB Vice President Vitor Constancio emphasising that nothing had changed regarding the ECB’s rate hike schedule.

Over the weekend, however, Bundesbank President and ECB Governing Council member Jens Weidmann was quoted by newspapers confirming discussions were underway on ending stimulus. He said that the ECB was working on dialling back its ultra-easy monetary policy, and added that policymakers are debating how expansive monetary policy should be, given the central bank’s inflation target.

Elsewhere, Bank of England (BOE) Governor Mark Carney spurred speculation over rate hike expectations. He was quoted making some hawkish comments suggesting that some removal of stimulus may become necessary if the trade-off between inflation and growth continues to diminish.

This comes just over a week after Carney had said that now was not the time to raise rates, fuelling conversations over whether these remarks represent a shift in the BoE’s longstanding “wait-and-see” approach.

In reaction, we saw the 10-year gilt yield spike higher along with other yields in Europe, while sterling gained on the week. Despite some scepticism from some market analysts on the overhang of Brexit-related uncertainty, an initial BOE hike by February 2018 has been priced in by markets.

European equities were lower across the board last week after its largest weekly decline since 2016. Bond-yields backed up and both the euro and sterling rallied on the back of the more hawkish central bank commentary.

There was a rush for banking stocks, as the reflation trade showed signs of coming back into play, while the US Federal Reserve’s (Fed’s) stress test results buoyed sentiment globally. All 34 of the largest US banks passed the second part of the annual stress tests. Bond proxies were unsurprisingly under pressure, which saw stocks in the utilities sector underperform, while tech stocks followed its US counterparts, lost momentum and pulled back.

In the United Kingdom, the Conservative government reached a deal with the Democratic Unionist Party, which in turn saw its legislative plan for the new parliament pass a crucial House of Commons vote.

As we begin the second half of the year, it’s worth noting that Greece was the best performing equity market in Europe over the second quarter, as creditors agreed to disburse a fresh €8.5 billion bailout fund in mid-June, allowing the country to meet its July debt obligations.

Americas

US equity markets ended the week lower as the re-emergence of the reflation trade rotation—when investors expect inflation to increase and rotate into inflation-friendly sectors—took hold. The Treasury curve steepened, with the 10-year yield up, while the US dollar fell on the week.

Asia

It was a quiet week for the APAC region. Japanese equities ended the week slightly lower on the back of underwhelming macro data. The Japanese unemployment rate jumped higher in May, industrial production declined more than expected,retail sales were disappointing, and inflation data came in as expected.

China outperformed the APAC last week as focus fell on the World Economic Forum in Dalian, China, and Premier Li’s accompanying commentary. The Premier predicted China’s GDP would hit its growth target, and highlighted China’s commitment to reforms, including further deregulation to allow more foreign participation in markets.

Elsewhere, Australian equities closed the week small higher, aided by the strength in iron ore and crude oil. West Texas Intermediate crude oil staged a bounce back last week and finished the week higher. Some market participants have suggested the weaker US dollar could have been a catalyst for the move, but there was also speculation that recent commentary had been overly bearish and was unlikely to get much worse in the short-term.

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