The environment is becoming more confusing for bond investors

Fixed Income

Despite the political noise in recent months, central-bank actions have remained important catalysts for bond markets, though with varying effect. The U.S. Federal Reserve (Fed) is following a gradual path of interest-rate hikes, and the European Central Bank’s (ECB)quantitative-easing (QE) program is likely coming to an end after two years. The Bank of England, on the other hand, is tending to be more pragmatic in light of Brexitand is temporarily willing to tolerate higher inflation. It is interesting to note that at the end of the quarter the ten-year government-bond yields in the United States were roughly as high as they were when the year began, while yields in Germany rose and in the UK they fell. This leads us to several conclusions:

1. As can be seen by the trend in interest rates and the U.S. dollar, the “Trump trade” has already retreated from an intermediate high. What this means for the future is anyone’s guess. It certainly doesn’t indicate an end to the U.S. economy’s euphoria about the new Republican-led Congress. But the first disappointment must have surely occurred after the administration’s bumpy start, which was sealed with the failure of health-care reform, thereby raising questions about Trump’s backing in Congress.

2. Interest-rate developments are driven by several factors that vary for each region. In the United States, there is almost an uncommon consensus regarding the Fed’s next steps, while disagreement over the ability of politics to stimulate economic growth is likely to increase. In the UK, the central bank needs to keep an eye on both the potential impact of Brexit and rising inflation. In Europe, on the other hand, the focus is less on actions than on forecasts. For although the ECB continues to buy bonds, rising Bund yields show that...

3. ...words are more powerful than actions when it comes to moving markets. This was already clear when the buying program was initiated roughly two years ago. Bund yields, peripheral spreads and the euro had their strongest reaction in the period that started with the first rumors in April 2014 up to the initiation of buying in March 2015. The latter even caused a renewed rise in both yields and the euro.

The ECB’s end to QE is likely to be different from the Fed’s

This observation will be an important one in 2017 because we expect the tapering discussion to flare up again no later than this summer. We also anticipate ECB buying volumes to decline starting in early 2018. It would be a mistake, however, to make a direct comparison with the Fed. While the Fed’s aim is to ‘merely’ ensure employment and price stability, things are a little more complicated for the ECB. The ECB also needs to keep interest-rate spreads in the periphery low, stimulate lending and keep the euro in check. All this for a heterogeneous monetary union, which, in our view, requires a slower, different kind of exit from QE. For example, bond purchases and key-interest-rate policies could be distinctly decoupled from one another. ECB president Draghi could continue QE until he is no longer worried about peripheral countries. If on the other hand, inflation sees a more sustainable increase, he could then start to adjust interest rates. The market is well aware of this dilemma, which makes it even more difficult to extract any clear meaning from the ECB’s words and actions. The problem with interpretation is that it offers no help in reducing the volatility of European bond markets.

The euro faltered long before the ECB’s QE

The euro already started to weaken with the first rumors of bond-buying from the ECB. As the buying began, the euro strengthened.

Bund yields and spreads surprise

Bund yields and premiums on peripheral bonds narrowed before, not after, bond-buying.

Politics trump macro consensus on currency markets

After President Trump failed to unite the RepublicanParty on the health-care reform, markets will closely watch his ability to push a tax reform through Congress. This is likely to affect U.S. yields, which are a dominant factor for U.S. dollar valuation. Its weakness primarily against the Japanese yen (JPY) came after U.S. yields started sliding in mid-April. We still regard this weakness as a consolidation. Once investors’ positioning looks clearer, we expect the dollar to strengthen again. However, this would require the negative Trump-related news flow to abate. Euro strength is based on strong macro data as well as fading worries around the French presidential election. The periphery’s yield spreadsagainst Bundsnarrowed as did the Bund spread against U.S. Treasuries, supporting the euro. Nonetheless, we view any near-term politically-driven appreciation as a selling opportunity. Concerning the yen, it still remains the most reliable currency if market volatility is rising. However, the Bank of Japan is unlikely to change its monetary course of fixing parts of the yield curve soon. Therefore, any rise in U.S. yields is likely to lead to yen weakness. Hence, we prefer to sell the yen into any further rally.

USD/JPY closely aligned with U.S. rates

Japanese yield stability makes the yen susceptible to U.S. yield changes.