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Following the market turbulence in the first half of August, financial markets had a quieter week. Volatility indicators, such as the Vix Index, were back below their 12-month average in the absence of substantive ‘new news' or tweets. 

Predictably, Trump has been using Twitter to continue to bash the Federal Reserve, seeking to bully them into cutting interest rates more aggressively. 

FOMC minutes described a decision to ease last month based on ‘global factors' and ‘risk management'. It certainly seems odd to see the Fed operating with an easing bias when the domestic economy continues to move along just fine. In the past couple of months, there have been signs of slightly higher inflation, robust consumer behaviour, a solid labour market and a pick-up in housing market activity related to lower mortgage rates. 

Ordinarily one would not be expecting the central bank to be cutting rates at such times as this, but it seems that Powell has been cowered into submission by the Commander in Chief and increasingly the Fed is looking like a flaccid follower of POTUS, without the political will or confidence in its own convictions. 

Of course, with inflation low, the potential cost from a policy error in taking rates too low may be modest for now.

However, it seems increasingly dangerous that Trump has put himself in a position where he seeks to control trade policy, monetary policy, FX policy and fiscal policy based on his own analysis and desire to maximise the US economy into the 2020 Presidential election, in order to maximise his own election chances.  

Global markets 

Global G3 government yields were little changed over the course of the week, though sentiment in risk assets was supported by a rebound in US equities from their early August lows. 

In rates markets, a first 30-year German auction printed at a negative yield received some attention - though in honesty - we have got used to sub-zero issuance in the two, five and 10-year parts of the curve for some time. 

There remains something strange in being asked to purchase an asset that guarantees to pay you back less than you paid for it. Indeed, there was a time in bond markets when you only received a write-down on your principal in the case of default. 

Perhaps if yields go much lower, we will need to re-think our risk framework in order to deliver a more normalised expected loss on all securities rather than thinking about credit risk as distinct to rates risk in a negative yield environment, where safe securities no longer guarantee preservation of capital - but rather are imposing a cost on investors for the privilege of perceived ‘safety'.

Political misunderstandings in Italy

In the eurozone, politics in Italy remained in focus. As widely expected, Prime Minister Conte stepped down after La Lega withdrew its support for the government coalition. However, President Mattarella has postponed any decision on new elections until next week, with Five Star now looking at forming a new government with the mainstream Democratic Party. 

If such a compromise is achieved, we see this leading to a material rally in Italian assets on the perception of a reduced political risk premium. It seems most investors are keen to portray Salvini and La Lega as Eurosceptics who harbour a desire to confront Brussels and ultimately leave the EU. It is this fear that has seen a substantial widening in Italian spreads in the past year. 

Ultimately, we tend to believe that most investors are very wrong on their understanding of La Lega. We don't think this party has its roots (in the North of the country), or its identity, committed to leaving the EU. 

Rather, we think that Salvini is keen for a reform within the EU and we may also be given to think that a right-wing government may be capable of making more of the market-based reforms, which are required to make the Italian economy competitive on a medium-term view. Yet we seem to be in a minority in this view for the time being.

Consequently, any move towards a new coalition without La Lega is seen as a potential blessing - and with the prospect of QE from the ECB just around the corner - it is possible to see how a constructive political outcome in Italy could be the basis for a further material narrowing in BTP spreads.

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