Markets faced risk off sentiment last week as volatility returned. Market weakness was ostensibly triggered by political concerns in the US as two of the president’s advisory councils were dissolved after the resignation of several key members. President Trump’s equivocal statements following clashes between white supremacists and anti-racist protestors have reignited indignation about his social and racial stance. The volatility highlights the risks posed by high market valuations in both equity and credit markets around the world. Bonds were pushed and pulled by widening credit spreads and rallying duration while equities fell. With volatility so low for so long, any rebound in uncertainty would always look and feel worse. So far economic data and corporate earnings remain robust. Some softening of Asian trade data is creeping into the numbers but at this point it is too soon to point to a slowdown.

Minutes of the ECB’s last meeting showed some equivocation around inflation expectations as well as concern around the strength of the EUR. Despite strong growth numbers inflation remains weak (1.3%), well below the 2% target of the ECB. Later this week at Jackson Hole, the US Fed gathers for a meeting that features ECB chair Mario Draghi as guest. The Fed’s plans are largely telegraphed so the show stealer will likely be Draghi as the ECB sits between rebounding growth, low inflation and a strong EUR.

A word about emerging market local bonds. While it is incorrect to say that emerging market local bond returns are entirely due to FX, and there is a definite contribution to returns from credit selection, it should be noted that the correlation between emerging market local bonds to DXJ are over 90% on a monthly basis over 10 years. A call on EM local credit is therefore a call on the USD and the USD has been weak. For EM local bond investors, the USD outlook is important. For now, there appears to be some momentum to the downside but the USD may find support if it turns out that the Fed is more resolute than its last meeting minutes, or that the other central banks, the ECB, BoJ and PBOC are a bit more patient in normalizing policy.

As for emerging market dollar bonds, the base yield curve may react to central bank signals in the coming days and weeks but the additional spread and the base USD curve are more predictable than the FX element in local currency bonds.