Following months of anticipation, the FOMC finally announced the initiation of its balance sheet reduction plan on September 20, and as many expected, the market reaction was muted. Fed leaders did a good job of telegraphing the move in the prior months, and the pace of reinvestment tapering will begin at relatively small levels before ramping up over the next four quarters. As such, agency MBS spreads actually tightened modestly immediately following the announcement.
Despite much headline noise related to political and geopolitical matters, the financial markets remained relatively calm throughout August. The S&P 500 was down as much as 1.8% by mid-month but ended the month slightly positive, and interest-rate volatility, both realized and implied, held near historically-low levels. That said, there are still several potential headwinds that could revive volatility from a nearly catatonic state.
The primary economic themes have changed very little in recent months. On the data front, concerns over recent weakness in core inflation readings continue to weigh on long-end yields and market inflation expectations.
For much of the second quarter, there was a dislocation between equity and fixed-income markets. Fixed-income markets responded to three straight months of weaker core inflation data, as well as the impasse in Washington regarding fiscal and regulatory reforms. As a result, long-end Treasury yields fell as much as 25 basis points (bps), and market inflation expectations fell to pre-election levels.
The primary economic theme in recent weeks has been inflation, or the lack thereof. In particular, core inflation has disappointed, surprising to the downside for the past two months. This weakness in consumer prices has been a headwind to the global reflation trade that took hold of the market back in August 2016.
The tone in global risk markets improved in the final week of April. A “less negative” scenario in the first round of the French presidential elections relieved some investor concerns of tail risk from Europe that had mounted in the previous weeks; and at least the announcement of the White House’s principles of tax reform was perceived to be a positive development.
The tone in global risk markets improved in the final week of April. A “less negative” scenario in the first round of the French presidential elections relieved some investor concerns of tail risk from Europe that had mounted in the previous weeks; and at least the announcement of the White House’s principles of tax reform was perceived to be a positive development. The S&P 500 had fallen nearly 3% from early March to mid-April, but it rebounded nearly 1.5% in the final week.
The political realm has monopolized the recent headlines from a financial markets perspective, particularly as it relates to the success of anti-establishment movements and the potential for significant policy changes. In the last 12 months, we’ve seen a successful Brexit vote and a Donald Trump victory; and in France, the anti-establishment Le Pen campaign is gaining momentum. All of these events present some degree of uncertainty as it relates to future economic growth and financial market stability. That said, monetary policy returned to the forefront in the last week of February, with even the most dovish Fed leaders publically stating that a March rate hike was a likely outcome. Prior to these statements, the markets were pricing just a 25% probability of such an action. In this economic overview, we will discuss tax reform proposals, the recent data trend, and the current tone from the Fed.
While there has been a bevy of political headlines in recent weeks related to future policies from the new administration, the markets have largely taken everything in stride, with the Dow Jones Industrial Average breaching the 20,000 mark for the first time ever. Fixed- income markets have held relatively steady as well, with both yields and spreads trending sideways during the first month of 2017. However, markets got a little choppy in the last few days of the month. Popular backlash to a controversial immigration order sparked a retreat in equity markets on concerns that the big three initiatives (tax reform, deregulation, and infrastructure spending) could be delayed or more difficult to push through given heightened partisan tensions. To that end, much of the post-election optimism in equity markets was related to the big three, particularly corporate tax reform.
There was a distinct shift in market sentiment in the final quarter of 2016. During the first three quarters, expectations of tepid global growth/inflation and subsequent increases in monetary accommodation in Japan and Europe, pushed government yield curves flatter. Further, expectations for a Fed rate hike in 2016 fell sharply, particularly following the unexpected Brexit referendum result. However, in the wake of Brexit, central banks were less dovish than anticipated, and government yield curves began to steepen from the summer lows. Weeks later, the U.S. election results accelerated that trend dramatically. In addition to expectations of less dovish central bank policy, market participants were also speculating on potential changes in fiscal and regulatory policies given the sudden shift in the Washington power regime. The market was already pricing in a relatively high probability of a December rate hike before the election, but the post-election increase in market inflation expectations and overall positive performance of risk markets sealed the deal.