The bond market is worried about what will happen when the Fed begins to unwind its balance sheet. Although the Fed has been very careful to tell the market that their process will be gradual and systematic, this is an unpresented event and the market has every right to worry. Witness the reaction in Europe when the head of the European Central Bank (ECB), Mario Draghi appeared to be more hawkish.
On June 2nd the ECB met and decided to remove the term “or lower” from their rate guidance language and forecast an improvement in Eurozone growth from 0.5 to 0.6 for the quarter. Inflation forecasts for 2018 and 2019, however, were lowered to 1.4% and 1.7%, respectively. There was no talk of tapering or phasing out of QE.
On June 27th at an ECB forum in Sintra, Draghi was more upbeat saying “all signs now point to a strengthening and broadening recovery in the Euro area.” He went on to say “the central bank can accompany the recovery by adjusting the parameters of its policy instruments.” Ten year German government bonds surged +12.5 bps and French government bonds were up 13.7 bps. For German bonds, it was the largest one day rise in twenty-two months.
At a press conference on July 20th, Draghi did not back away from his slightly more hawkish tone in Sintra, but he did not provide any additional information on policy tightening moves. The council does not want the market to speculate on future policy changes. Bonds traded as high as 0.557% and the euro broke through 1.160 for the first time since August 2016.
For investors wondering what the market reaction will be to central banks reducing their balance sheet, the experience of the ECB may tell us something. Just the hints of a change from Draghi and the bond markets in Europe moved significantly higher and have stayed there. Better economic growth is feeding the expectation of higher rates, but central banks are also pushing out their forecasts for higher inflation. If inflation doesn’t pick up, and we see no reason why it should, current policies may be in place for longer than people expect. When the tightening does come, the reaction may be similar to what we have seen recently in Europe.
We are watching inflation closely, but are still comfortable with our credit and high yield exposures. The firm has felt for a long time that growth would be moderate and that inflation would be well contained.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.