Kevin Flanagan, Senior Fixed Income Strategist, WisdomTree, believes that bond markets continue to look towards the US’s Federal Reserve’s (Fed) utterances for direction, but increasingly believes in the Fed as they look to achieve their targets.
Commenting on the recent market volatility, Flanagan (pictured) says: “What we see in Europe and the US, with a 20 basis point increase in 10-year Treasury yields in a week (as of 12/10/2018), is that the catalyst to that kind of environment was the comments from the Fed chairman, Jerome Powell, on the rate hike cycle, specifically that the policymakers could go past neutral in their current rate hike cycle”.
In terms of the outlook, the Fed has forecasted one more rate increase this year and three for 2019 and any hint that this might not be what is going to happen could impact the markets.
“The bond market has been responding to competing forces such as the removal of central bank policy stimulus versus flight-to-quality issues stemming from concerns surrounding emerging markets, trade uncertainty and the Italian budget saga.” Flanagan says.
“Concerns around China’s growth prospects as well as the situation in Italy are two areas of market focus. It seems every time we think we have put some of Europe’s issues behind us, up pops some new information. A few years back we had Grexit and now we have speculation the Italian government could leave the Euro. In addition, the targets for the Italian budget deficit to GDP are higher than the EU is comfortable with and that has also led to anxieties regarding the credit rating agencies.”
This push-and-pull in the markets seems to be the landscape going forward.
Flanagan comments that in Europe specifically, there had been improving economic numbers with the European Central Bank (ECB) appearing to be more comfortable about hitting inflation targets.
“Nevertheless, the Italian budget-related saga keeps making headlines resulting in a flight-to-quality trade,” Flanagan says.
The markets seem to be operating under the impression that new purchases for ECB quantitative easing will end in December for Europe but the plan for reinvestments has yet to be made public with speculation centred on these reinvestments going into longer rather than shorter durations. The question is what comes next as the markets have largely discounted that news?
In terms of broader policy Flanagan says the guidance from the ECB suggests no rate hikes through to the summer of next year.
In terms of upcoming Euro-related bond action, headlines regarding Italy’s government debt will be front and centre.
“As of the day of this writing, Moody has already downgraded Italy’s credit rating by one notch and we’re expecting S&P to weigh in within the next few days.”
Downgrades have previously occurred in the US and Flanagan believes there could be either a negative outlook assigned or an outright downgrade coming for Italy. “Sometimes after this type of veil of uncertainty is removed investors breathe a sigh of relief they can focus on other things in the market. It will be interesting to see how that plays out.”
For US fixed income asset allocation, Flanagan says that WisdomTree has primarily been focusing on credit over rates, but more recently we have been dialling back our overweight to credit given where we are in the current cycle. “From a broader global bond market perspective, the theme is that tailwinds from the extraordinarily accommodative central bank policies are being reversed.”
Looking forward, Flanagan sees the Fed leading the way with rate hikes and the Bank of Canada and the Bank of England also continuing their gradual path of raising rates.
“Brexit and Italy continue to be focal points looking ahead. The ECB looks to be the last participant who will raise rates among the group of central banks discussed here. Bond investors should get used to the process of normalisation and prepare their fixed income portfolios, accordingly.”
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary.