Investor focus turns to monetary policy divergence (Fed, ECB), with trade concerns hurting investor sentiment
The Fed raised rates, as expected, by 25 bps to 1.75%-2.00% on the back of: i) above-trend US GDP growth; ii) increasing inflation (towards 2%); and iii) a decline in the unemployment rate to a 45-year low (3.75% in May). The Fed also upgraded its economic outlook (see Economics).
As a result, FOMC projections for future rate increases now indicate 2 additional hikes by end 2018 (up from 1) to 2.50%, and 3 hikes by end 2019 to 3.25%, while the expectation for end-2020 (3.50%) remained unchanged. The overall tone of the press conference was hawkish, with Fed Chair Powell highlighting the strong economic outlook and downplaying risks stemming from the international environment (“trade wars”, Italy).
On the other side of the Atlantic, in view of progress towards a Sustained Adjustment in the Path of Inflation (SAPI), the ECB expects to reduce the monthly pace of the QE from €30bn/month currently, to €15bn/month as of October 2018, and to end net asset purchases in December 2018.
In a less anticipated move, the ECB enhanced its forward guidance regarding interest rates (currently: 0% and -0.4%), citing that it expects them to remain at current levels at least through the summer of 2019. As a result of the dovish interest rate guidance, the euro depreciated by 1.9% against the US Dollar on Thursday to $1.157 (the largest one-day move since June 24th 2016).
Prospects of a US–China “trade war” appear to be escalating. On Friday, the US announced tariffs of 25% on $50bn worth of imports from China, in two stages, the first including $34bn worth of imports, effective from July 6th and the second ($16bn) to be implemented later.
China retaliated soon after, announcing its own list of tariffs on $50bn on US imports. Reportedly, the US is close to finalizing a further list of Chinese imported goods, worth $100 bn, on which it will impose a 25% tariff (US: total goods imports from China: $542 bn | China: total goods imports from US: $162 bn).
US equities were flat wow (-0.2% on Monday | +3.7% YtD). The more domestic-oriented US small caps (+0.7% wow | +10.2% ytd) continue to overperform against large caps (flat wow | +4.1% ytd), with the latter negatively affected by trade concerns. The exporter-heavy DAX30 in Germany (Domestic Earnings: 22% - Other European: 30% - Rest of the World: 48%) also took a hit on Friday/Monday (cumulative decline of 2.1%).
The front-loading of the anticipated rate increases by the Fed pushed up US short-term treasury yields by 5 bps wow to 2.55% (2Yr) and led to a flattening of the US government bond yield curve, with the 10/2 spread falling by 7 bps wow, to 37 bps (lowest since August 2007).
Regarding euro area periphery bonds, the dovish ECB guidance led spreads over the German Bund down sharply. 10-year Italian spreads narrowed by 48 bps to 221 bps, Spanish spreads by 13 bps to 89 bps and Portuguese spreads by 19 bps to 142 bps.