Again, Trump was dominating the news this week, but financial markets also moved their focus to increasing political tension in Europe, higher inflation expectations and the earnings season.
Bond markets update
All the spotlights were on Trump this week, but bond markets hardly reacted to all the turmoil. They were either resilient or reacting to other drivers instead. German Bund and US Treasury yields moved a little bit lower, while corporate spreads – both investment-grade and high-yield – moved slightly higher, all within tight trading ranges.
Emerging market bond spreads also moved within tight trading ranges, around the lows from before Trump’s election in November. At these lows, emerging market bonds are expensive, considering the risks that are building for emerging markets from the protectionist policies of the new US administration. As we fear that the current developing weakness in emerging market currencies may spill over to emerging market bonds, we reduced our stance on this sub-asset class from neutral to negative (see also the Investment Strategy of 1 February).
Bond markets hardly seemed to react to Trump and ignored the Fed meeting this week. They did, however, react to higher inflation numbers and increasing political tensions in Europe. Long-term inflation expectations (five years) touched 1.8% again, indicating that markets now believe the European Central Bank (ECB) will actually reach its inflation target.
We do not expect core inflation to begin a sustained upward trend, though, until the turn of next year. As such, we continue to think that the first ECB rate hike will take place in 2019 and not in 2018. The ECB is also not likely to further reduce its bond purchases in the second half of this year already. Not only because core inflation remains too low and stable, but probably even more because sovereign spreads moved sharply higher across the board. Italy is one of the drivers of this development. The Italian court ruled to remove a second round of voting to achieve an absolute majority for the winner. This has opened a way for former Italian Prime Minister Matteo Renzi to make a quick comeback in elections before this summer, without much risk of the anti-euro Five Star Movement seizing power.
Markets have now moved back into an environment that looks somewhat like the period before last year’s Italian referendum, due to ongoing problems in Italian banking and market speculation that the asset purchasing programme could end this year already. This suggests that buying opportunities could now be developing.