Mark Dowding is partner & co-head of Investment Grade Debt at BlueBay Asset Management.
A Goldilocks portrayal of an economy, which is neither too hot nor too cold, saw both bond yields and risk assets rally in the past week in the wake of the Federal Reserve’s (Fed) announcement that it would raise rates by 25bp at this week’s meeting.
The message from Janet Yellen was designed to be ‘steady as she goes’ with forward looking guidance on rates essentially unchanged from the December projections. Notwithstanding this, the Fed dots continue to suggest two further hikes this year and three hikes in 2018, a trajectory which is some 50bps higher than that built into money market pricing in Eurodollar contracts.
In addition, the Fed is basing these forecasts on assumptions of steady growth around 2.1%, yet we see clear risks to the upside of this number with economic data continuing to suggest acceleration in activity.
During the past week, the NFIB survey of small business confidence remained close to the level recorded last month, confirming the sharpest upturn in this indicator in the past 30 years.
Meanwhile, the NAHB survey of home builders posted a new high for the cycle, suggesting that the outlook for residential investment is strengthening at the same time as the backdrop for non-residential investment also improves. These forward looking indicators portend well for the economy as we move into the spring and on this basis, we believe that it is appropriate to expect the next Fed rate hike in June this year.
Should plans for fiscal stimulus have advanced by this date, then we believe that the Fed may firm their rate trajectory at that meeting and we would emphasise that having recently observed how few commentators expected a March hike, only to shift their view, so we remain very much on track to see the four rate hikes we were looking to see in calendar 2017.
In addition, we would argue that with tax cuts and infrastructure spending adding to economic momentum in 2018, the case for higher rates could be even more compelling next year and so we are surprised by the sanguine view on the Fed which the market has adopted. Seemingly holding onto the idea that ‘gradual’ means no more than two hikes per year is the wrong assessment of the Fed reaction function in our way of thinking.
Meanwhile, in Europe, politics were the focus in the past week with the Dutch incumbent, Mark Rutte routing the right wing extremist Geert Wilders in the national polls. Although Wilders was never likely to be part of any governing coalition, it was striking that his defeat coincided with a high level of turnout among Dutch voters.
Following the defeat of a right wing extremist in the Austrian Presidential elections earlier this year and signs of collapsing support for the AFD in Germany, it is perhaps encouraging to see centrist parties holding the day across Europe – though clearly the biggest test of this comes in the French elections, which are now clearly in view.
Although we continue to see Emmanuel Macron defeating Marine Le Pen in the second round of polls, uncertainty will persist for the time being and we are still two months away from knowing who the winner will be.
Political headlines also impacted markets in the UK, with the Scottish Nationalists pushing for a second independence referendum. In Northern and Southern Ireland there are also growing calls for a reunification referendum and as complexities around borders and grievances that Parliament in Westminster cares insufficiently for the regions, so it continues to strike us that a UK break-up is a more likely consequence than a eurozone break-up in the wake of the Brexit vote.
Risk assets were boosted by further equity market gains following the Fed and also by the Dutch results. However, a sharp fall in oil prices earlier in the week continued to weigh on the energy sector as worries with respect to over-production return to the fore. Nevertheless, a robust global growth outlook should limit the downside in commodity prices in our view and with the US dollar weaker following the Fed, this was also a factor helping to underpin risk appetite in commodity sensitive credits in emerging markets.
Strategy performance was negative over the week due to the rally in short dated US yields following the Fed. Although this was partly mitigated by gains from holdings in corporate credit, with European financials trading very well, weakness in energy related names detracted from returns.
A long US dollar bias also negatively impacted performance on the week, as did a long position in the Icelandic krona. Iceland has been a strong performer in the past year and the government decision to remove capital controls is fundamentally bullish news with respect to this position.
However, there has been a short term pull back in the valuation of the krona, as the authorities seek to limit further gain by encouraging currency outflow but limiting currency inflow. Nevertheless, we think these moves will prove futile with interest rates close to 6% and should the central bank slash rates in the months ahead, as we feel is likely, then this should lead to solid gains coming from a rally in Icelandic yields.
As we look forward we feel that bullish sentiment may continue to drive risk assets ahead in the coming week. This, in turn, should limit any further rally in US yields and with markets pricing in far less monetary tightening than the Fed, there seems limited scope for short rates to rally further, underlining the asymmetry in this position.
Of course, the only real problem with the Goldilocks story is that we know that come the end of story, the Bears will see her off. However, for now, it continues to feel like it is time to party like its 1999 – and indeed it was interesting to see pictures of another Prince getting in on the act in the last few days.
