1. The French Connection
The major talking point in European Investment Grade Fixed Income markets last week was the sudden and violent widening of non-core markets against Germany. It was most evident in France, but also occurred in Italy, Portugal and Greece (the latter for very idiosyncratic reasons to be fair). The primary cause of the widening was the dramatic fall in popularity of the Conservative candidate Mr Francois Fillon, caused by a scandal about alleged payments to his wife. Having been the clear favourite, Mr Fillon saw his popularity plummet, with some commentators calling for his withdrawal from the race. In theory, that would leave the way clear for independent candidate Emmanuel Macron to face the National Front’s Marine Le Pen in the second round head-to-head poll on 7 April. The sudden bout of nervousness around French government bonds is a little surprising, since the polls have consistently predicted Mrs Le Pen would advance to the second round, but be defeated in that second round, no matter whether she faced Mr Fillon or Mr Macron.
1. Euro-area Inflation: Frankfurt – We Have A Problem
We mentioned in last week’s blog about the likelihood that Euro-area inflation would show a significant increase when the January numbers were released. We began to get an indication that the number might be quite strong when Spain’s inflation number topped 3%, but even we were surprised when the number printed at 1.8%, well above market expectations of 1.5% and the previous December number of 1.1%. In fairness, the core number remained unchanged at 0.9%, but that won’t be much comfort to the German press nor the Bundesbank, who saw headline German inflation rise to 1.9%. This will increase the pressure on the ECB and ECB President Mario Draghi to consider their monetary policy stance, especially in light of the strong Q4 2016 GDP number of 0.5% quarter-on-quarter, and the strong start to 2017 as evidenced by the recent Purchasing Managers’ Index (PMI) numbers. Perhaps it was in anticipation of this problem that Mr Draghi noted there were four conditions the ECB would need to see before being convinced that a sustained inflation adjustment had occurred:
- Inflation converging to the ECB’s medium-term target of “close to, but below 2%
- Convergence must be sustainable
- Convergence must be sustained without monetary policy support
- Convergence must be across the whole of the eurozone
In reality, we are still some distance from those four conditions being met, and we expect that the inflation numbers will peak in April before falling back towards the 1.5% level. Inflation breakevens have risen quite a bit recently, and that is largely what has driven nominal bond yields higher. Real yields haven’t really moved much, and remain at historically low levels. We believe this could drive the next leg higher in nominal bond yields – an increase in real yields. We think being short real yields in Europe is the most attractive way to position for higher inflation in Europe over the coming months.
Part three in a series. Paresh Upadhyaya is Senior Vice President, Director of Currencies, US.
In my previous posts, I discussed the three factors that will fuel the USD rally in 2017: fiscal stimulus proposal (USD Bull Market: Key Drivers in 2017), US rate normalization and idiosyncratic factors (A 2017 USD Bull Market? More Factors to Consider). While the prospects of a stronger rather than weaker USD are asymmetrically greater, two key risks could lead to a divergence in USD performance between G-3 currencies and emerging markets.
1. Changes in US Trade Policy
The US President can unilaterally impose trade sanctions and tariffs. During his campaign, President Trump emphasized free, but fair trade and has explicitly singled out China, threatening 45% tariffs. In addition, there has been discussion on the need to make changes to the North American Free Trade Agreement (NAFTA). We believe the market may be underestimating the prospects of some form of protectionist policies that will have consequences in currency markets. Continue reading
Qinwei Wang is an Economist.
One of the major debates on the future of China relates to the potential growth with some pundits predicting a sharp and unavoidable fall in Chinese growth throughout 2020.
We have looked into the causes behind China’s slowdown in recent years and it appears that some common concerns about the country’s potential growth are perhaps overdone. If China can continue to push structural reform, the current pace of growth is perhaps near its floor for this multi-year transition. Continue reading
1. A Week is a Long Time in Politics
We spent a part of last week’s blog discussing the UK Supreme Court’s verdict on triggering Article 50, and the first round of the French Socialist elections. Given all that happened last week, we thought it appropriate to share our thoughts on market implications. In the UK, the Supreme Court, as anticipated, ruled that Parliament should vote on the triggering of Article 50. The verdict was widely anticipated, and had little effect on markets. We still think UK Gilts could underperform in the coming months. In France, we noted last week the surprise victory of Benoit Hamon in the first round of the Socialist Party elections, and over the weekend Hamon won the nomination of the centre-left Party. The baseline scenario is still that the Conservative party candidate Francois Fillon will face, and defeat, Marine Le Pen in the second round of the Presidential elections. But recent polls suggest Mr. Fillon is losing momentum, and last week he faced accusations about his wife’s involvement in his campaign. This has led to speculation that independent candidate Emmanuel Macron could emerge as the candidate to face Ms Le Pen in the run-off. Currently, Mr Macron polls even higher than Mr Fillon against Ms Le Pen. We believe markets would react favourably to either a Macron or a Fillon victory, with French bond spreads tightening against Germany. Finally, the Italian Constitutional Court’s ruling last week means that a second-round head-to-head vote-off between the two most popular parties (in the event of no party achieving 40% of first round votes) is unconstitutional, and no longer an option. This is important, as it conceivably could have given 5Star a chance of being the sole party in government. We believe the ruling may bring forward the possibility of early elections (perhaps in Spring or early Summer 2017). However, it appears likely that some form of coalition could be the outcome of any election. Whether that coalition would have a long or effective life is another matter, and was the primary reason for Italian sovereign BTP’s underperforming following the ruling. We like Italian BTP’s, particularly when bought on a spread basis against German Bunds, and would see any weakness as a buying opportunity. Overall, we think that political risk is slowly being worked through in Europe. We now have some clarity on the UK Brexit path and timeline, the French elections are beginning to show the emergence of a market-friendly Prime Minister (either Mr Fillon or Mr Macron) and with yesterday’s ruling, the chances of 5Star being a majority party in an Italian government have receded. That gives us reasons to be optimistic on peripheral European sovereign debt at current valuations.