As many countries start to emerge from economic and social lockdown, we are beginning to see just how much the world has changed over the last two months. Economic data is being released thick and fast, mostly telling us what we suspected – that the global economy has taken a massive hit.
Two sets of data released over the last few days have stood out for me. Last Friday the United States released the employment survey. The Non-Farm payroll report is usually released at 8.30 am ECT on the first Friday of the month and is the subject of many an office sweepstake – the margin of victory being around 5,000 jobs one way or the other. In recent months this report has shown an increase in US payrolls of around 200,000 per month. The unemployment rate is also released at the same time and in February this was recorded at 3.5% of the workforce. Last Friday, the Non-Farm payroll for the month of April fell by in excess of 20 million jobs and the unemployment rate rose to just under 15%. These are unprecedented, extraordinary numbers and best seen visually (see graph below). This is far worse than sustained in the Financial Crisis over a decade ago.
This is temporary and we would expect some reversal in the months to come as the US economy reopens, but some economists are expecting the unemployment rate to remain over 10% for at least the next 3-6 months, which is alarming.
The other piece of data released earlier this week that caught my eye was monthly inflation. Inflation rates had been expected to fall as a large part of the variability of the inflation rate is related to movements in oil prices. Oil prices have been very weak as demand has fallen, so it was no surprise to see prices decrease in the sectors that have oil as a key component (i.e. transport etc.), but what was more eye-catching was the weakness in other sectors of the economy. This led to core inflation rates (i.e. excluding food and energy components) recording their biggest monthly fall on record with the year-on-year rate falling to 1.4% – something not seen since 2011 in the aftermath of the Financial Crisis. The sheer size and speed of the demand-shock related to economic and social lockdown has led to a fall in the market clearing price level for many goods. Unless demand rebounds equally as quickly (which we don’t expect) low prices are set to remain and we should expect similar falls in inflation rates across the world.
These two pieces of data encapsulate for me the reason why investors in US government debt should not feel too concerned about losses despite the low level of yield available (albeit much higher yield than other quality government bond markets). Unemployment tells us why the US FOMC will not be raising rates in a hurry and may look at further easing of policy. Inflation tells us why the future value of the cash flow from fixed income will not be eroded away in real terms.
At the time of writing, the number of new cases of Coronavirus are still increasing, although the pace is thankfully declining. This is widely thought to be as a result of the measures taken in China to prevent people mixing with each other such as enforced and often unpaid holidays, travel bans, conference bans, and even in Beijing – a crackdown on family parties. Several countries have introduced travel bans and many companies around the world have banned travel to China and Hong Kong.
Whilst the health benefits of such measures appear to be paying off, there will be a less beneficial effect on the Chinese and global economies. Economists are finding it hard at present to estimate the effects, but what they can all probably agree on is that GDP growth in Q1 for China will be substantially lower. Given China plays such a large part in the global supply chain it then follows that we can also expect a substantial ripple effect around the globe. One US Federal Reserve Open Market Committee (FOMC) member, Robert Kaplan, yesterday suggested that it could reduce US GDP growth by as much 0.4 %.
There will also be an effect on inflation via two channels. Firstly via the oil price. Inflation around the world is very low and movements in the oil price have a much larger effect on inflation rates than in previous eras (when there was more inflation in other parts of the economy). Spot oil prices have fallen nearly 20% this year in reaction to the weaker global economic outlook and some of this will quickly pass through into lower fuel costs and lower inflation rates. Some economists are beginning to factor this into forecasts and US CPI is now expected to fall to below 1.5% year-on-year by mid-2020. The second effect is via a weaker Chinese currency and will take longer to impact inflation trends. Quite sensibly, some easing measures have been announced in China and it is possible that there will be more to come. This should stop any currency appreciation – thus making Chinese exports cheaper to the rest of the world. This reduces input costs into many supply chains, making it easier for producers outside China to keep prices low.
Central Banks should be concerned at this development, especially the ones that have an inflation target as their objective. In Europe and the UK the outlook for inflation was already subdued, but both the Bank of England and the ECB are very reluctant to cut rates any further. The Bank of England failed to cut rates in January despite some dire economic forecasts (see piece written by James Lynch – Will the new boyfriend be any more reliable?). The ECB is also cautious because they have a new president and are conducting a policy review. There is a suspicion creeping into central bank circles that the long term effects of negative interest rates are also turning out to be harmful thus tying the ECB hands from any further easing. Already the Swedish Central bank has exited its negative interest rate policy whilst also downgrading economic forecasts. Similarly, the Bank of Japan remains stuck when it comes to monetary policy.
That just leaves the US Federal Reserve. Inflation in the US is likely to record around 2.3% year-on-year in January, but this may be the only month in 2020 that inflation is above 2% as it declines into the summer months. Falling inflation with a weakening economy should lead the FOMC to continue cutting rates in 2020.
As expected, the US Federal Reserve cut interest rates again yesterday. In total, the US Federal Reserve has cut 75bps this year, almost completely reversing the hikes of 2018; the target range for US Fed Funds now stands at 1.5-1.75%. The committee remains split, with two members still dissenting against rate cuts, but the committee’s top dove Bullard did not argue for a bigger rate cut, unlike previous meetings.
As for what is next, the statement and Chairman Powell’s press conference offer few clues. According to the Fed the economy remains sound, but there are concerns over exports and business investment, the depressing effect of trade discussions, and “global developments”. This justifies the cut, but any future cuts are not being signalled – hence the reporting of this current move as a ‘hawkish cut’. In his press conference, Powell emphasised that their stance was “likely to remain appropriate” for some time. As we’ve already seen this year, less forward guidance may well lead to greater volatility as markets struggle to predict the Fed’s next move. A line saying the Fed will “act as appropriate to sustain the expansion”, seen in multiple prior rate announcements, was noticeable by its absence in the statement. A return to rate hikes, though, is not on anyone’s radar: Powell said only a “really significant” rise in inflation would cause a re-evaluation.
In theory we should regard every rate cut as being the last one, otherwise the central bank should have announced a bigger cut. In practice, most economists expect further weakness in the economy and hence further rate reductions into 2020. For financial markets in the near term though, the move is positive. Cutting the risk free rate will encourage investors to move out of cash and into other assets – the S&P 500 closed at a record high on the day of the announcement.
Expectations are building in the bond markets that the US Federal Reserve is about to embark on an easing cycle starting in July, and market pricing suggests that rates will be 0.75% lower by year-end than at current levels.
To date, Chairman Powell has given little away, affirming at every opportunity a neutral stance with the promise of reacting in either direction if necessary. The FOMC meets next week and analysts will scrutinise the statements, the Summary of Economic Projections and the Press Conference for further clues. In our opinion, there is a good chance that the markets will be left speculating for a bit longer about FOMC thinking, and that the neutral stance will be retained.
We come to this conclusion based on the published economic data, which shows that the US economy is still solid and performing better than the US Federal Reserve had expected so far this year. The pace of expansion is admittedly slower in 2019 than was the case last year, but remains around potential and the Economic growth forecasts that will be published are likely to show an upgrade. Inflation on the other hand is likely to be revised down slightly. Both observations would represent an outcome that the FOMC should be delighted with, and would suggest that there is no need for rates to be either higher or lower at present.
The infamous “dot plot” – which shows how the committee members see interest rates evolving over the next few years – will in all likelihood continue to show an upward path in rates into 2020, completely at odds with market pricing. The validity of the dot plot has to be questioned in an easing cycle as the FOMC does not pre-plan rate cuts, and is instead usually reactive to events, crises or recession. The FOMC also forecasts a long run rate, which is currently at 2.75%, which again looks vastly different from bond market pricing. Using the forward curves, rates are expected to be around 2.15% in 10, 20 and 30 years’ time, illustrating how far the bond market has ‘front run’ Federal Reserve policy expectations.
So why would the FOMC start to lean towards easier monetary policy, and what would be implied by a move to an easing stance? Firstly and probably most importantly, by signalling an ease the implication is that we have seen the top of the interest rate cycle. That should surely mean the long term rate must be lowered substantially, closer perhaps to the average rate of the last 10 years which is a mere 0.5%. This would perhaps be a bit extreme (as it does include the immediate post-crisis period), but even over the last 5 years it is still less than 1%. This is more than 100 basis points lower than that implied in the market, and over a whopping 175 basis point difference from the FOMC’s current estimate.
Thus, reverting to an easing stance is hugely significant, and to my mind too big a statement to make at the current juncture when the US economy is performing well, employment is still rising and financial conditions are easing. Should they do so however, yields across the whole of the fixed income universe have a long way to fall. A change in stance like this may well also be positive for riskier assets, as the move is perceived as less of a response to concerns but more a “recalibration” of Fed thinking about what the “neutral” rate for the economy is. On an international comparison, US interest rates are far higher than in Europe and Japan, as President Trump is so fond of pointing out.
The FOMC have surprised us a couple of times this year. We should remain alert to more surprises as they could be even more meaningful than what we have seen already.
“Italy will not be another Greece” said former Italian Prime Minister Matteo Renzi in July 2015. Nearly four years later their sovereign debt markets show that they may be closer than ever before. Italy can borrow for five years at a rate of 1.85% and Greece can now borrow at a slightly lower rate of 1.73%.
So what is behind this, and why are the debt markets pricing equivalent credit risks for the two countries? Back in 2015, Italy could borrow for five years at 1.34% while Greek 5-year debt reached around a 20% yield at one stage. Greece was effectively still shut out of the debt markets.
Coming back to today and taking Greece first, a slow renaissance has occurred. Firstly, there has been recovery in the economy. Secondly, economic reforms have been made and the country has sustained a surplus in public finances. Finally and importantly, Greece returned to international bond issuance. Debt metrics have not really improved yet, but the deterioration has halted and as long as the economy continues to grow, like Ireland and Portugal in recent years, the credit outlook should continue to improve. Credit ratings have already started to reflect this, with all the major ratings agencies upgrading over the last year. Admittedly they remain a long way from investment grade, but things are going in the right direction.
Another factor that supports Greek debt is its scarcity, which may come as some surprise. Although the Greek government debt-to-GDP ratio remains at a very high 181%, a high proportion is funded by various bailout programmes and therefore does not need to be repaid or refinanced in the short term. Current funding needs are thus very low and are usually done to refinance more expensive loans, thus reducing debt servicing costs via issuance.
By contrast Italy, although rated investment grade, is showing some very worrying trends again. The current government is expanding the budget deficit and the ratio of budget deficit to GDP is expected to rise again this year. The ratio of total debt to GDP is rising and currently standing at a record high of over 130% GDP.
All of this debt is financed via the bond market which will have to take the strain if this problem is not tackled via greater issuance. If credit ratings deteriorate, the pool of available buyers will also decline, particularly if a sub-investment grade rating becomes likely. This is why the EU is just about to open an Excessive Deficit Procedure (EDP) for Italy. The EDP is nothing new in the EU, as even Germany has been subject to one in the early years of the Euro, and only Sweden and Estonia have escaped the procedure in recent years. Spain has just exited the procedure having entered it in 2009.
The aim of the EDP is to act as an “early warning system” for fiscal policy. It requires national governments to present plans as to how their nations will return their debt positions to that set by the Maastricht criteria i.e. a budget deficit of less than 3% of GDP and a total debt to GDP ratio of 60% over a period of time. If nation governments fail to comply, ultimately a fine of 0.2% of GDP can be levied. In practice, despite many countries being in the EDP for many years, no fine has been applied.
The current government in Italy shows very little sign of being compliant to the EU, so perhaps this will be tested in the years to come. U-turns, however, are not unprecedented. Returning to Greece, the Prime Minister Alexis Tsipras, who has presided over Greece’s return to debt markets, famously swept into power on anti-austerity rhetoric which was quickly abandoned in the face of the 2015 crises. Four years later the bond market approves, though perhaps not the population – Tsipras has recently lost heavily in the European elections and has just called a General Election.
May 2019 could go down in the history books as the moment when UK politics really changed – the month where the two dominant political parties lost their way.
Whilst the political risk gauge has certainly increased post-European elections, financial markets have been expecting turmoil for a few weeks now. Sterling has weakened as the probability of a “No deal” Brexit, once thought to be off the table, has started to increase again. Gilt yields have fallen, with the 10-year gilt now yielding less than 1.0%. The yield curve has now started to price in the possibility that the next move in the Bank Rate will be down rather than up, in contrast to the message that the Bank of England have been giving for some time.
At this level of yield, the outlook for fixed income is turning less positive and requires a change in message from the Bank of England to sustain it. The next meeting of the MPC is in June, but they are unlikely to change message at that point unless there is a crisis (economic rather than political) developing. It is more likely that the Bank of England will reassess in August and guide policy at the same time as they release the quarterly inflation report. At that point it appears unlikely that Brexit negotiations or arrangements will be any further forward than they are now. The leadership change within the Conservative party is expected to be completed by mid-July, leaving little time for any further negotiation. The Bank therefore are unlikely to make any changes to their underlying assumption that departure from the EU will be orderly, even if the political developments raise the risk of an alternative scenario.
Another reason why the Bank may change their guidance is if the UK and global economies start to show significant weakness. The UK economy has performed better than expected so far in 2019, but a large part of this performance was to do with economic activity being brought forward ahead of the initial Brexit deadline at the end of March 2019. Some reversal therefore should be expected in the second quarter; with the delay and uncertainty continuing, expectations of the weaker trend in investment are likely to continue from now until the end of the year, and possibly for even longer.
With this in mind, we tend to come down on the side of the Bank of England validating the move lower in gilt yields by changing their message on interest rates to a neutral position from the current hawkish bent. From neutral they then can open up the possibility that if the economic weakness is prolonged, then a cut in bank rate is probable. However, we see this validation to come later in 2019 – most likely in Q4 – thus some consolidation in the gilt market is due in the short term. We expect yields on 10-year gilts to trade in the range of 0.8% to 1.1% over the summer, with the proviso that if it becomes apparent that economic conditions are deteriorating faster than currently expected, then we would expect the Bank of England to act sooner and yields can fall further again.
Financial Markets often become fixated with elections, some more than others. The upcoming European Union elections will choose 751 MEPs to the European Parliament, which along with the European Commission and the Council of the European Union forms the tripartite legislative function of the EU.
Up until very recently the UK was not going to participate in these elections, but now will for obvious reasons. 73 MEPs from the UK may yet take their seats on 1st July 2019. Quite who the UK public will elect and for what reason is difficult to read. A protest vote either from a lack of turnout or by virtue of the representatives that are elected seems the obvious conclusion. Turnout is often low in these elections across Europe, and the current record low was recorded in Slovakia in 2014 where voter turnout was a mere 13% of the electorate.
But will it matter in any way? Do these elections have any impact on economic policy in either the UK or in Europe?
Taking the UK first. Interest rate policy is set by the Bank of England and is in no way influenced by politicians in Brussels. Despite what some UK politicians might say, fiscal policy is set by the UK government. The Brexit process is a far bigger influence on the outlook for the UK economy and that is currently in the hands of the UK members of Parliament. There is likely to be a backlash against the two main parties in the UK which may accelerate the political demise of their leaders, which, although newsworthy, is again not something the Bank of England will react to.
In Europe, the elections again may well be newsworthy. There is predicted to be a rise in representation of the populist parties (Lega in Italy and National Rally in France) but the two largest groupings expected to remain in control are the European Peoples Party (EPP) and the Party of European Socialists (S&D). The European Central Bank again is independent of politicians and will not react to any change in parliament make-up and fiscal policy remains the responsibility of national governments. Oversight from the EU remains, but despite what some politicians are saying, this is unlikely to change.
So interesting, noisy and complicated, but not going to change a lot. Interest rates are low and staying low for a long time to come.
There is a danger in writing about Brexit that the article is out of date before it hits the screen, but I‘ll have a go anyway.
At the time of writing, the way forward for the UK and the EU still appears exceptionally unclear. The “backstop” is the main issue of contention, with the Irish Government, the EU, Northern Ireland’s DUP, and the notorious sub-group of the Conservative party, the ERG, all determined not to blink.
This reminds me of a famous (and highly recommended) episode of Dr Who from 2007 entitled ‘Blink’, where the good Doctor manages to restrain the powerful Weeping Angels for eternity. In the episode, the Weeping Angels (the baddies) are a powerful species of quantum-locked humanoids with the characteristic that if they are observed they turn to stone – hence their appearance of statues covering their faces. By covering their eyes they cannot see each other and thereby avoid literally petrifying each other. Of course, the Doctor manages to engineer a situation where they remain staring (and not blinking) at each other and thus everlasting petrification follows.
One can only hope that the current political leaders’ refusal to blink won’t leave us trapped in the same way…
US Monetary Policy throughout 2018 was a simple tale to tell; rates have increased by 0.25% per quarter, US Monetary Policy has been well signalled and the US Federal Reserve have been clear about the motivation for such a policy.
But as the year draws to an end, speculation has turned to 2019, and things become cloudy. So what factors are causing the uncertainty?
Firstly, the current levels: The fear of the end of the cycle. After each rate increase, by definition the level of rates is getting closer to what is perceived to be the “neutral rate” for the economy. This rate is estimated to be around 2.75% to 3.0%, so the closer official rates get to it, speculations begin about the end of the cycle.
Secondly, the outlook for economic growth: The immediate effects of the tax cuts are fading and 2019 looks a lot less rosy than 2018.
Finally, global economy: To put it politely, the rest of the global economy is less buoyant than it was 12 months ago. Stresses are evident in a number of emerging markets, particularly in China.
As US economic growth dips, this could mean the US Federal Reserve will be less resolute in their stance that global factors will not influence US policy.
So, how much more have interest rates got to rise in the United States? Given all I’ve said already, the maximum looks set to be around four moves of 0.25%. The minimum? Two moves of 0.25% …which follow the Fed’s 0.25% increase yesterday. This would take the upper bound of the Federal Funds Rate to 3.0%, the so called “neutral” rate. We would err on the side of caution (i.e. two rate increases) given that, in this economic cycle, interest rates have never risen as fast as one might expect, mainly because inflation has been so low throughout the recovery. This is the one factor that could take the number of rate increases higher as the US Federal Reserve has a twin mandate of both economic growth and inflation.
And what about rate cuts? Speculation is rising, partly because the US yield curve has now inverted slightly. Rate cuts seem unlikely (although it is obviously always a policy option in the event of a crisis). A more likely candidate for policy easing in 2019 could be China.
So, monetary policy divergence seems likely to be a feature of 2019 with rates in the US tending to rise and interest rates in the other parts of the globe either unchanged or lowered.
“No plan for Italy to leave the Euro”
Claudio Borghi, Head of Lower House Budget Committee
Presumably Signor Borghi said this thinking that it would reassure Italian financial markets. It doesn’t seem to be working as of the time of writing, so maybe the question should be “Will the Euros leave Italy?”
Last week the Italian government released their new three year economic plan, complete with an increase in the budget deficit via increased fiscal spending (i.e. the citizen’s income) and some optimistic estimates for economic growth. On the face of it, it doesn’t look like a very big fiscal expansion, but when you have a total debt level of around 130% of GDP you don’t need a very big fiscal expansion for questions to be asked. Those questions are being asked by the European Union much to the chagrin of Italian leaders.
So what does the EU have to do with it? As part of the strengthening mechanisms put in place after the last Eurozone crises, all Eurozone countries signed up to the monitoring of their fiscal plans, including Italy. There is no desire for further bailouts in the Eurozone and these procedures were put in place to provide an “early warning system”. The EU is reacting exactly as their rules would suggest and Italian bonds and other financial assets are taking the strain as non-domestic and domestic investors withdraw their investments and thus their Euros from Italy.
So what happens next? In terms of the Italian timetable, further detail regarding the budget for 2019 will be released around 10th October. If it is in line with their three year economic plan then the EU will not react favourably. And nor may the ratings agencies which represents the really significant risk – and this is what is driving markets now. Currently Italy is rated Baa2 by Moody’s with a negative outlook. A downgrade to Baa3 is likely and a negative outlook may be maintained – so just one move away from a junk rating. The implications of the world’s third largest bond market moving to junk are enormous. The flight of capital from Italy would be vast.
In time, the knock-on effects will be that policy somewhere will change. It could be that the Italian politicians change fiscal policy, or there is another change of government. What is unlikely though is any action from the European Central Bank (ECB). The ECB cannot start Quantitative Easing again, they cannot cut rates, and their hands are tied unless the banking system comes under stress. There is a mechanism for bailouts and the mythical Outright Monetary Transactions (OMT) policy, but these options are not easy to execute and would only be applied after sufficiently large amounts of Euros from Italy have moved to other parts of the Eurozone. Any of these policies are completely unacceptable to the current Italian government in its present state.
Lastly it is worth mentioning that given the growth and popularity of passive and index tracking funds across the investment management industry, these funds will not be able to reduce their allocation to Italian assets unless they are removed from their benchmarks. These funds are a low fee way of accessing bond markets, but investors must consider whether that is what they really want for their bond market allocation in this more challenging market environment.
Do you want low fees but full exposure to Italian bonds? Consideration of paying up for the optionality of not having that exposure must be worth a thought.
Monetary policy in Japan has got into a bit of tangle. Back in 2016 the Bank of Japan announced that in addition to managing asset purchases and interest rates on deposits, it would also target yields on long term Japanese government debt. The target was a yield of 0% and since then yields on ten year bonds have been anchored at this level. Arguably this has been a success, but on the other hand a consequence has been the level of asset purchases falling, resulting in the so called “stealth taper” and thus a reduction of monetary stimulus which was unlikely to have been the bank’s intention.
Maybe as a consequence of this slightly contradictory policy, the Bank of Japan at its most recent meeting announced that it would allow a greater volatility in the yield on ten year bonds, with the yield now being allowed to rise as high as 0.2 %. Quite why the bank decided to do this is difficult to read. Maybe bowing to pressure from the banking sector that would like a steeper yield curve; possibly a desire to inject a little more volatility in the bond market; or perhaps a very small signal that monetary policy can be tightened? But does Japan need higher rates? On the face of it – no. Inflation is still low and although the economy is reasonably firm, higher rates are likely to strengthen the Yen which may act as a dampener to activity.
However, there is one bright spot on the horizon. Wages in Japan are now rising faster than at any other time over the last 20 years. Not only that, the rate of increase is rising faster than in other major economies.
||Annual Wage Increase (%) 2018
||Annual Wage Increase (%) 2015
The increase is now notable and could be a precursor to the end of the deflationary era in Japan – something we will be watching very closely.
If this is the case then we can continue to expect much more speculation over Japanese monetary policy and much more volatility in bond markets worldwide.
Last night the Federal Open Market Committee (FOMC), the body responsible for settling interest rates in the United States, met and announced that there would be no change to monetary policy. Its guidance however, is that rates will increase again in September. Also, there was no change made to the rate of reduction in the size of its balance sheet. In the current quarter the rate of reduction per month is $40bn ($24bn from US Treasuries and $16bn from Agency/MBS). This rate is due to increase to $50bn per month in the fourth quarter of the year. Market participants had not been expecting any change but there may have been some expectation that the Fed would signal a reduction in the pace of increase, or at least provide a hint of how accommodative it believes its policy is and therefore how close it is to the peak in interest rates. Little was forthcoming however.
In addition, yesterday the US Treasury announced its plans for US government debt sales over the next quarter and again the sizes of debt auctions have been increased to fund the widening US fiscal deficit. Extra funding is still predominantly focused in the shorter part of the yield curve and via bill issuance. Bill issuance is again expected to increase in the next quarter and this is likely to continue to put pressure on money market rates. In turn this is likely to add to US Dollar strength and funding pressures in the weaker Emerging Markets that have to look for US Dollar funding. The implications of increased US rates coupled with an increase in US Treasury Bills and US Government Bond issuance provides a challenging backdrop to riskier asset classes.
Italy is back in the news again with the last minute attempt by populist parties “The League” and “The 5 Star Movement” to form a workable government. It had looked as if co-operation was impossible and markets had resigned themselves to the possibility of more elections, or their favoured option of a non-elected technocratic government. Not democratic and inherently unstable, so quite why this was deemed a good option was short-sighted.
Instead, Italian bond and equity markets have suffered some volatility in recent days as the prospect increased of the two populist parties getting together to attempt to govern. There is little in common for the two parties who are united only in their desire to take power themselves and to stop the established parties from governing. Who is appointed Prime Minister and Finance Minister will be very important, as well as the policy agenda. Any signs of policy sense breaking out may be regarded very positively and isn’t entirely out of the question. There have been examples in the past of ‘populist’ governments reversing policy direction once in power on several occasions in Europe. Notably in Greece, where the Alexis Tsipras’s Syriza even held a referendum regarding austerity and then chose to ignore it and follow policies as specified by the EU, the ECB and the IMF. In Portugal, the current government (supported by the Communist party) were elected on an anti-austerity message but again has followed more orthodox fiscal policies once in power.
Developments in Italy will be keenly watched. If the populists prove to be reasonably sensible after all, the outlook could be quite positive and Italy can join the club of countries that enjoy an upgrade in credit ratings. To date it has been left behind whilst structural reform languished.
The world of scrolling news is a strange one. Headlines stream all day with the really important ones, as designated by a robot somewhere, coming up in RED, but occasionally one of the yellow ones catching your eye and provoking a moment’s thought.
Today has been one of those days. Whilst sipping my afternoon cup of tea (I am from Yorkshire after all), I noticed the headline:
U.S. Debt Load Seen Worse Than Italy’s by 2023, IMF Predicts
Really? I thought. Surely not. It is well known that Italy has a public sector debt problem; it was involved in a small funding crisis not so long ago. But the US?
Intrigued, I read the story behind the headline. And true enough, the International Monetary Fund has produced forecasts for the G7 group of countries suggesting that, if correct, the US government debt to GDP ratio will be as high as Italy’s in 2023 at around 117% of GDP.
Some further thought on the two countries… One has a large current account deficit (US), the other a current account surplus (Italy). One has a heavily indebted private sector and a low savings rate (US) and the other a high savings rate and low level of indebtedness (Italy). Which country is most likely to suffer the next funding crisis?
Something has been happening to interest rates in the United States this year and it may be one of the myriad of reasons that markets are a bit unsettled. Interest rate policy from the US Federal Reserve has been well flagged and entirely consistent with what has been signposted. But it isn’t US Fed policy that has been the main problem.
The US Federal Reserve announced in October of last year that it is starting the long-awaited reduction in its balance sheet, thus reducing the amount of excess reserves within the financial system. The best way to think about this is that on average the US Federal Reserve is selling bonds back into the banking system that are then bought by banks thus reducing the amount of liquidity/reserve that the banks hold or need to place in money market instruments.
At the same time the supply of these instruments has increased dramatically. As a result of the 2018 shenanigans with the US budget and debt ceiling, the US Treasury has ramped up bill issuance massively in February and March. Newly passed tax reform has also made it more advantageous for US companies to raise funds from issuing Commercial paper in the US market, rather than raid cash from their foreign subsidiaries.
What this has meant is that for the first time since the financial crisis, the Fed funds rate is no longer a good guide to financial conditions in the US. For example, in the table below we look at how the different measures of short-term interest rates have changed this year:
||1 January 2018
||27 March 2018
|US Federal Funds upper bound
|3-month Treasury bills
|3-month $ Libor
|3-month Top Tier Commercial paper
So although official rates have been rising quite slowly, actual borrowing rates have been rising twice as fast in 2018. It is little wonder that markets are a bit nervous; the last time this occurred was during the financial crisis. The difference this time being that this is not a credit or solvency issue. It’s a supply and demand issue and the effect should begin to fade as the supply demand imbalance reduces.
There will be a lot written about the General Election in Italy on 4 March 2018.
We thought we’d add a few numbers…
Silvio Berlusconi tops the charts of time spent as Prime Minister since World War II. Elected four times and is the current leader of Forza Italia and the Centre Right coalition. He is 3rd in the list of time served as Prime Minister since the formation of Italy in 1861. Only Mussolini and Giolitti have served for longer. Is he going to try and make it up to 2nd place?
The number of houses that make up the Italian legislature: Chamber of Deputies and the Senate. Both are up for election in this year’s General Election.
The number of major parties or coalitions contending to form a government: the Centre Right coalition, the Centre Left coalition and Five Star Movement.
The number of general elections that have been held since Italy adopted the euro. This is the 5th.
The number of political parties that make up both the Centre Right coalition and Centre Left coalition.
The number of Prime Ministers since Italy adopted the euro (Berlusconi served twice)
The number of parties contesting the 2018 General Election.
The number of elections since World War II.
The age of Luigi Di Maio, Prime Minister Candidate for the Five Star Movement (M5S), who entered the Chamber of Deputies in 2013.
The number of governments since World War II
The age of Matteo Renzi, leader of the Democratic Party (PD) and the Centre Left coalition, former Prime Minister, resigned in December 2016 following the loss of referendum regarding electoral reform.
The age of Silvio Berlusconi, leader of Forza Italia and Centre Right coalition, more life experience than Renzi and Maio put together and that is just taking his age into account! Amongst many controversies he was convicted for tax fraud in 2013. As a result of this conviction he has been banned from public office until 2019. It remains unclear who would be Prime Minister therefore in the event of a Centre Right victory.
The predicted majority for the Centre Right coalition in the Chamber of Deputies based on opinion polls taken 10-11 January 2018.
The current basis point spread that Italian debt trades over German bunds.
The highest level of spread that Italian debt traded at, in the run up to the French election.
The number of seats in the Senate up for election.
The number of seats in the Chamber of Deputies up for election.
The size of Italian government debt as at November 2017 (euros) = 132% of GDP as measured at the end of 2016.
In its last monetary policy meeting of the year, the European Central Bank (ECB) kept monetary policy unchanged.
There were no surprises regarding policy or signalling from the Governing Council which was very much as expected given it was only in the last meeting that the ‘recalibration’ of policy was announced.
The staff forecasts announced were a welcome Christmas present for the ECB and the Eurozone as a whole. Economic growth was revised up well above market consensus levels: in 2017 to 2.4%, 2.3% in 2018, 1.9% in 2019 and 1.7% for 2020. This is a very impressive outlook given trend growth is estimated to be around 1.5% each year.
Inflation forecasts though remain low and heavily dependent on prospective oil prices. In 2017 it is estimated to be 1.5%, 1.4% in 2018, 1.5% in 2019 and 1.7% in 2020.
The market reaction was muted. Bond markets have become less sensitive to the growth outlook, focussing on inflation and the level of cash deposit interest rates (still negative in the Eurozone)…a situation that we believe is likely to pertain for some time to come.
Swiss National Bank
The Swiss National Bank (SNB) kept interest rates and monetary policy unchanged today.
Despite recent modest currency depreciation, the National Bank continued to reiterate that the currency remains ‘highly valued’ and thus it remains committed to maintaining its policy of negative interest rates and willingness to intervene in foreign exchange markets as necessary.
Forecasts regarding the economy were also updated. Inflation rates were revised up in 2018 and 2019 to 0.7% and 1.1% respectively. GDP is forecast to increase by 2% in 2018, compared with 1% in 2017.
We expect the SNB to maintain this policy for the foreseeable future, yet at present money market curves are priced to suggest that it will increase interest rates ahead of the European Central Bank. In our opinion this is an extremely unlikely scenario unless the Swiss franc depreciates materially.
This is something we are looking to exploit in our absolute return funds via relative value trades.
Over the years some of us fixed income fund managers have had to endure much leg pulling from our colleagues that manage assets in other more ‘exciting asset classes’. Boring, dull are adjectives I‘ve heard whispered in corridors or by the coffee machine, perhaps they weren’t talking about the asset class but I prefer not to think about that. The financial crisis quietened many down for a bit as industry professionals fell over themselves in the stampede to learn about duration, convexity, the forward forward curve and other bond jargon.
I have defended the asset class many times over my career. I have found it an extraordinarily interesting and varied part of the financial market to work in. Where else could I combine my interest in mathematics, economics, statistics, current affairs, human behaviour, debate and discussion, all with the ambition to add value to our customers’ hard earned cash?
But …and there is a but….2017 has turned out to be somewhat boring in government bonds and this is a surprise. 2017 was supposed to be full of risks; there was Trump, there is Brexit, we have had a number of elections, some haven’t even resulted in a government yet! There was the independence vote in Catalonia and the first known flight to Brussels for refuge by Senor Puigdemont. What next? The US Federal Reserve has raised interest rates and is reducing its balance sheet. The European Central Bank has tapered and the Bank of England has raised interest rates. There has been a lot to consider.
German government bonds however have sailed serenely through these events, 10-year bonds are yielding 0.36% at the time of writing, this is also the average yield over the last 12 months, the median is 0.37% and for around 75% of the year, the yield has deviated only 0.1% from this level. Not hugely exciting although quite extraordinary when you consider it.
Very exciting when compared with Japanese bonds. In Japan the central bank operates a policy of Yield Curve Control where it targets a yield of 0% for 10-year government bonds. To do this it buys an awful lot of bonds if the yield rises too much and stops buying if it falls. And now, the market has the message and 10-year yields have traded in a mere 12 basis point (0.12%) trading range all year. The yield today is 0.03%. Again quite extraordinary.
In the US the MOVE index which measures the volatility of the US bond market is at the lowest levels in the history of the index. Only UK gilts have tried their best to cause some angst but even so, 10-year UK debt was yielding 1.33% on the first trading day of the year. At the time of writing, 10-year gilts yield 1.30%.
Being reasonably experienced in European bonds I can just about recall the time when, just over 25 years ago, Standard & Poor’s awarded Italy its first Foreign Currency Long-Term Debt rating. Back then, Italian debt was denominated in Lira and withholding tax was payable on the coupons by investors. The gross yield on a 10-year bond was nearer 12.5%. Interestingly the post-tax differential between Italian domestic debt and German domestic debt was around 300 basis points, much higher than the 150 basis points of today. The spread however is not strictly comparable with current markets as it was in the pre-Euro period and therefore incorporated an element of currency risk.
The credit rating awarded was AA+. Over the last 25 years, Standard & Poor’s has downgraded Italy eight times, culminating in a rating of BBB- in 2014. Yields have been volatile but currently are close to 25-year lows at around 1.75%, despite this trend of continual downgrades; the interest rate and inflation environment have had a greater influence than the credit rating.
Last Friday, the trend changed and for the first time ever, Standard & Poor’s upgraded its rating for Italian debt. Only one notch to BBB with a stable outlook. But an upgrade nonetheless.
Reasons cited were the improved economic outlook, an improvement in government finances and the resolution of some of the problems in the banking sector. Further upgrades could occur if progress is maintained, which we think is reasonably likely.
A word of caution however; we may have to wait another 25 years before a rating of AA+ is to occur.
On the face of it, the US Federal Reserve shouldn’t have surprised the markets last night, but by announcing their decision to keep interest rates unchanged and to start their programme to reduce their balance sheet, markets were taken aback – the USD dollar strengthened and US Treasury yields rose.
The opening statement was bland and changes to the economic projections and the ‘dots’ were minor – which was entirely as expected. However, over the summer, questions regarding the low level of inflation and the technical difficulties of reducing the balance sheet in the face of a lack of progress in raising the debt ceiling (now pushed forward) had been raised. There had been a suspicion that the US Federal Reserve might delay or signal a shallower path of policy tightening and markets had moved accordingly. 5 year US Treasury yields had fallen around 0.15 % between June and September and the US Dollar around 5% on a trade weighted basis.
Last night the surprise was that these suspicions were proved incorrect and a reversal occurred.
What this means for the rest of the world is also of interest. Some recovery in the US Dollar, particularly versus the Euro, may have implications for monetary policy in Europe too. A stronger US Dollar will mean there will be a lower hurdle for ECB tapering.
The European Central Bank’s (ECB) Governing Council decided yesterday to keep monetary policy unchanged in the euro area but signalled strongly that, all being well, policy would be ‘recalibrated’ at the October meeting. So we will all have to wait until later in the year to see the results of this meeting and whether the pace and makeup of purchases (currently spread across three programmes, the PSPP, CBPP, and the ABSPP) will change.
Mr Draghi did rule out any change to the amount of each bond it can buy (issuer limits) and also ruled out any change to potential sequencing of its removal of accommodation – in other words, the projected path of reducing asset purchases first and then moving interest rates remains unchanged. This outcome is unlikely to come as much of a surprise to financial markets as few had been expecting any clarity at this stage in the year.
The ECB also announced its latest staff forecasts for the Eurozone economy in 2017, 2018 and 2019. Economic growth has been revised up in 2017, reflecting the current positive environment, but forecast were left unchanged for 2018 and 2019. Inflation however was revised slightly lower for 2018 and 2019, reflecting for the first time some pass-through from the strength of the euro. The revisions made were quite small so while there was some note of euro volatility in the accompanying statement, it signalled that (at this stage) the ECB is not too concerned over the external value of the euro.
We continue to expect tapering to start in 2018, and think that some change in the composition of asset purchases is likely given the ‘shortage’ of German government debt. In our view this will add to the relative attractions of peripheral European debt, already performing well as the outlook for the Eurozone economy continues to improve. As long as there is no political hiccup, the better economic outlook will continue to benefit credit ratings across the region, with most countries in the periphery likely to retain a stable or positive outlook.
Both German and Spanish CPI was released today for August. They can be added to the expanding list of countries in the European area where inflation is coming in higher than expected. Germany reported 1.8% year-on-year, with Spain at 2.0%.
To put these figures into context:
- The average inflation in Germany over the last 5 years was 1.2%, and 0.6% in Spain.
- The average inflation in Germany since the euro was formed was 1.5%, and 2.2% in Spain.
- The average inflation in Germany since Bloomberg records began (in 1997) was 1.4%, and 2.2% in Spain.
- The inflation rate in Germany when the ECB started quantitative easing (QE) was 0.2%, and -0.8% in Spain.
- The inflation rate in Germany when the ECB expanded QE (in June 2016 post the Brexit vote) was 0.1%, and -0.9% in Spain.
- The inflation rate in Germany when the ECB announced the extension but reduced amount of QE (the first taper) was 0.5%, and 0.0% in Spain.
France and Italy release their figures tomorrow, so it will be prudent to keep an eye out for that. With regard to inflation, these countries remain the laggards with France at 0.8% year-on-year and Italy at 1.2%. After the figures today, I would expect these to come out higher than forecast – with the obvious implications for ECB policy.
Greece returned to the international bond markets last week with its first issuance since 2014, which at the time was its only issuance since the European Sovereign Crisis when the vast bulk of its debt was ‘restructured’. This return to the market is another small step in the long road back to financial health. Around half of the issuance was bought in exchange for existing debt but some new investors subscribed to the deal, some at least likely to be from outside Greece.
In a small way this should help the Greek banking system by injecting funds from outside Greece into the country, and allowing the amount borrowed under the Emergency Liquidity Assistance (ELA) programme to continue to reduce – something that is probably necessary before the 2015 capital controls are removed. Since 2015, many changes have occurred in Greece and it may surprise some that the outlook is looking much more favourable. Economic growth has turned positive, helped by firm Eurozone economic performance. Unemployment levels, although very high, have been falling since 2014. The fiscal position also looks better, with Greece recording a primary surplus in 2016.
The outstanding level of total government debt is still enormously high and is almost universally agreed as being unstainable in the long term. That said, in view of these more recent positive developments, Greece has been upgraded by rating agencies Standard & Poor’s and Moody’s over the last 12 months. Still rated at a worrisome B- at best, but at least going in the right direction. For this reason Greece offered a credit premium of near 5% over German debt in its recent issuance. This compares with the 1.3% spread that Portugal offers, the next ‘worst’ of the major countries that are active in the debt markets.
The credit trends are not isolated in Greece. Two of the other former ‘PIIGS’ countries, Ireland and Spain, have also seen upgrades in their credit ratings in recent years, and while Portugal’s rating has remained stable, Fitch has upgraded its outlook to Positive. Only Italy has seen a downgrade recently – but even there the outlook looks, for the short term, reasonably sanguine. The revival in economic growth and the long-awaited action regarding the banking system should mean stability for the foreseeable future. The good news can continue.
We have a lovely custom here in the Kames office of buying chocolates for the team after we return from our holidays. Occasionally one of the healthier team members veers into the natural sugar space, but in general the tried-and-tested combination of cocoa and sugar goes down the best. Summer is a good time for treats, many from far-flung parts of the world, but Europe remains our collective clear favourite.
Europe was an uncertain place last summer. The UK had just voted to leave the European Union and the whole of the region suffered a jolt of confidence as an uncertain future beckoned. A year later, the EU has recovered from the shock, weathered the subsequent political storms and the economy is growing stronger quarter by quarter, whilst the UK languishes.
Since the election of French president Emmanuel Macron, business and economic confidence has strengthened across the EU and is now beginning to be reflected in the ‘hard ‘data. This morning, first estimates of GDP growth in the second quarter for 2017 were released for France, Spain, Austria and Sweden, all higher than expected. The French economy grew at 0.5%, the Spanish 0.9%, the Austrian also 0.9% and the Swedish a punchy 1.7%. Their annual growth rates are 1.8%, 3.1%, 2.2% and 4.0% respectively. This augurs well for releases from other countries for the same period and the Eurozone as a whole may have grown close to 2.2% over the last 12 months. By contrast the UK’s growth rate was 0.3% in the second quarter and 1.7% over the last year.
This renewed confidence is being felt across the whole of the continent – even Greece has recorded an increase in GDP in the first quarter of this year. Unemployment across the region is falling while bank lending is growing moderately. The difficulties of the past five years are receding. This is being reflected in the strength of the euro, not only against the pound (some may find their holidays a touch pricier this year) but also against the US dollar and latterly the Swiss franc. The Swiss franc has been widely used as a safe-haven currency over recent years, used to gain European exposure while avoiding the euro. The currency has appreciated substantially over recent years to much protest from the Swiss. This week the President of the Swiss National Bank, Thomas Jordan, reiterated that in their view the currency was overvalued and that they would do all they can to weaken the currency by keeping monetary policy accommodative and by intervening if necessary.
We fully expect the European economic renaissance to continue, and if it does we may all be swapping our post-holiday Belgian bonds, as well as chocolates, for Swiss ones in the months to come.
It is early days yet but it looks like Theresa May is going to be returned as prime minister as the Conservatives form a government with support from the Democratic Unionist Party (DUP). On first glance it seems a bit of a mess but taking a closer look at the results there are some positives.
Firstly, the share of the vote taken by the mainstream parties has risen as a proportion of the vote. Or putting it another way, the share of the vote taken by the extremes has fallen. The country as a whole has moved towards the middle. In England, from Right to Left, in Scotland from independence (as supported by the SNP) towards unionist, and in some places, from Anti-EU (Tory) to EU (Liberal Democrats).
What does this mean for policy? Perhaps the same – moving towards the centre, compromising on the issues that the UK faces, which could be a positive outcome.
So for example, the probability of a second independence referendum in Scotland has been reduced. Many SNP seats were lost on this issue. Scotland is not usually prone to voting Conservative but in this election they represented the strongest voice against Independence.
Negotiations with the EU will have to be less extreme, particularly as the DUP does not want a ‘hard border’ with the Republic of Ireland. You could make the argument that a cross-party team could be appointed to lead negotiations in the national interest, but maybe that is too farfetched. However, with the decline of UKIP, it doesn’t seem likely that the current position can move any further anti-EU.
With regard to tax and fiscal policy, we can probably expect some movement towards the left, i.e. higher taxes and higher public expenditure; the Conservatives lost badly on this issue to Labour. We can probably expect the pledges regarding minimum wages being fulfilled and some of the cuts that were floated (e.g. school lunches) being abandoned.
What does this mean for UK fixed income? Probably very little, with easier fiscal policy being outweighed by reduced extremist political risk. And sterling? It could be positive depending on the Brexit negotiating stance. Monetary policy is likely to stay stable thus supporting fixed income, sterling has depreciated a lot versus both euro and US dollar over the last year, so this political event – as messy as it is – in my view is unlikely to push sterling to new lows.
One of the biggest surprises so far this year has been the strength in the Italian economy. In Q1 2017 Italy posted a 0.4% increase in real GDP, the strongest quarter since the European Sovereign Crisis. Meanwhile composite PMIs are reaching new highs, unemployment is finally falling (now 11.6% down from a peak of 12.6% in 2014) and inflation has picked up to 1.5% from around 0% where it has been for over two years.
True, total government debt to GDP is still high at 132.6%. For this ratio to fall, nominal growth must exceed the budget deficit (2.4% of GDP) and there is a small and rising chance that this can be achieved in 2017.
However, politics as always is getting in the way; political developments is certainly the key negative from the rating agencies’ standpoint right now. The failure to reform the senate last year was a step back in the reform process and the current electoral law reform is progressing slowly.
For Italian government bonds this means volatility over the next few months. The latest day an Autumn election can be called is 3 September, for a 22 October vote. And the precondition is the electoral law being passed in July. Irrespective of when the vote takes place, I think it is extremely unlikely that leaving the EU/Euro as a popular policy would get off the ground (around 67% are in favour of using the euro, 15% are opposed and the rest don’t know) but this won’t stop markets being concerned about it.
Where this differs from our experience in France earlier this year is that the current spread on Italian government bonds (over bunds) is already pricing in some political risk. The Italy/Bund spread is currently 200bps, having been as low as 100bps last year. Our view currently would be to buy on further weakness rather than chase the market. We expect there to be some good opportunities to make money through this election period, keeping in mind the potential for volatility.
It seems a done deal that the Conservative Party will win the 2017 General Election and will increase its majority in the House of Commons. The Conservatives are around 17 points ahead in the opinion polls and the Labour Party’s election campaign to date can best be described as unfortunate. Senior party members appearing to have little knowledge of basic arithmetic and the leakage of the manifesto before the official launch haven’t helped.
The gilt market and sterling are heading into this political event with a reasonable sense of calm; unusual in the context of the last three years of potentially destabilising political events, starting back with the Scottish Referendum in 2014. The expectation appears to be that an increased majority in the House of Commons gives Theresa May the negotiating power to negotiate a ‘better’ Brexit. Many have interpreted this as ‘softer’ i.e. closer to the EEA (European Economic Area) or EFTA (European Free Trade Area)-type arrangements, rather than the imposition of hard borders and resorting to WTO rules regarding trade. This has led to sterling strength against the euro and the US dollar in recent weeks.
Unfortunately it is not clear what her Brexit negotiating stance is yet. On closer inspection of the opinion polls, we see that it is the UKIP support that has collapsed and switched to the Conservative Party. The Conservative manifesto has not been published (or leaked) yet so we are still to see if the currency and bond markets have made the right assessment of a ‘better’ Brexit. What we do know is that Theresa May is firmly rejecting the idea of Free Movement of Workers, with her commitment to reduce immigration to less than 100,000 per annum. This concept is completely at odds with the pillars of free trade in the EU, EEA and EFTA.
Sterling has appreciated over 2% on a trade-weighted basis over the year to date. Gilt yields have fallen from 1.5% at the 10-year maturity to closer to 1.0% as concern over imported inflation abates. It seems to me that although the outcome of the election is of little dispute, the outlook for Brexit and the UK remains uncertain, and the risks rise again on 8 June.
On Tuesday this week the European Central Bank released their quarterly Bank Lending Survey for the Eurozone. This is a comprehensive document available in the ECB’s website that covers the lending behavior of 140 banks across the Eurozone. Click here to view. The headline message is clear: both credit supply and credit demand are improving. This augurs well for a continuation of the often under-reported recent robust economic performance of the Eurozone, with many commentators preferring to speculate about political change instead.
Another feature that also stands out is that the banking sector as a whole detests the policy of negative deposit rates. 85% of banks surveyed reported in the first quarter that it was having a negative effect on net interest income. This is nothing new as each survey since the negative deposit rate was introduced has provoked a similar reaction. From the ECB’s view, volumes of lending are up as a result of the policy and lending rates are down, so a successful policy to some extent nevertheless. This somewhat controversial policy is benefiting those in the economy that want to borrow money whilst causing a headache for the banking sector.
As the European economy recovers, speculation is now turning to the idea that the ECB is going to start to remove some of the emergency policies that were put in place last year. So what will they do first, raise the deposit rate or stop quantitative easing? Raising the deposit rate will benefit the banks by elevating net interest margins and it may also have the effect of increasing short term interest costs within the economy. Stopping QE first may have the effect of increasing long dated bond yields and increasing long term borrowing costs, maintaining banking sector dissatisfaction.
The debate is on! The ECB meets today to talk about monetary policy. At this meeting there is not expected to be any change, but the Eurozone bond market participants will be listening keenly in the post meeting press conference to see if they can detect a bias to one or other policy. Yield curve and cross Eurozone market opportunities, and also credit sector opportunities will present themselves if a bias is signaled.