Yesterday the Federal Reserve (Fed) concluded its September monetary policy meeting without any change in its key interest rate.
While the decision has become a consensus call in the aftermath of the Chinese-induced volatility shock, it was not without effects on markets. In particular, the US government yields moved lower yesterday evening and this morning a similar trend took over Euro area sovereigns.
After the US 10-year yield dipped below 2.2 per cent, the German yield is due to also be repriced lower, undoing the upward movements experienced earlier this week when supportive US retail sales data underpinned bets that the developed economies could avoid negative slipover effects from China.
In my opinion, the Fed’s decision shows that the extent of the slowdown in China is not yet clear or, more specifically, that it is hard to judge whether a hard lending can be avoided. Authorities have for some time tried to foster a transition to a growth model that is less dependent on debt, infrastructure spending and exports but this necessitates a strong vision and investors’ confidence, both of which are hard to assess or predict.
Thus, the slip in sovereign yields is in my opinion justifiable and should soon be followed by an over performance of the Euro area sovereign bonds relative to their US counterparts as the former is undoubtedly more vulnerable to sub-par global growth and inflation.
To put it differently, investors might have recently become too optimistic with respect to Europe’s resilience and the Fed’s decision should serve to remind them that external risks should not be underestimated; after all, just a few days ago the Europe Central Bank’s (ECB) leader reckoned that risks have become more unbalanced.
Looking at the Euro area yields this morning, there are also indications that markets are gradually pricing-in a higher probability of a change in the ECB’s QE programme to counteract the recent downgrade in global growth outlook.
At least, this is how I interpret the slip lower in peripheral yields after yesterday’s decision; the 10-year Italian yield slipped to below 1.8 per cent as I am writing from 1.9 per cent yesterday and the Spanish bonds of similar maturity now yield less than two per cent, compared to 2.12 per cent yesterday.
As I touched upon earlier, such reactions are justified and likely to gradually gather pace although temporary and partial reversals could occur as the wild volatility experienced earlier this year seems to have left investors more pro-active in realising profits.
Such movements bode well for investors in EUR investment grade bonds as such securities trade somewhat in sync with government yields; the credit spread is relatively small and large variations are rather unlikely in the current environment. Having said this, the revival of bond issuance after a quite summer can diminish the benefits accrued by corporate bond yields from lower benchmark yields.
As regards the impact on high yield bonds (i.e. lower rated), much depends on whether markets avoid a turn in sentiment and the extent to which speculations around “QE2” will fuel the search for yield.
The US corporates should be better positioned given that they operate in a more supportive macro environment where outlook uncertainties are comparatively lower.
Indeed, the Fed statement and Yelllen’s press conference highlighted that the recent developments at home have been positive and that the delay reflects more the lack of inflation risks.
On a related note, the staff projections and the Fed’s comments showed that the latter could be to some extent explained by the still sizable labour slack and that the unemployment rate has to be interpreted in conjunction with other metrics such as involuntary part-time jobs and labour participation rate.
Consequently, the Fed once again decreased its estimate for unemployment rate at which inflation risks increase.
This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.