ECONOMIC UPDATE This time last year, financial markets were very optimistic that a new political
In recent weeks, the two themes capturing the most attention from financial markets have been 1) the tax reform effort, and 2) the White House nominee for Fed Chair. In addition to fiscal policy (tax reform) and monetary policy (Fed leadership), the narrative could be expanded to include inflation and real growth. These factors had generally provided a boost to financial markets over the last several weeks, but the tailwinds subsided somewhat in late October.
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.