The Federal Open Market Committee (FOMC) raised the funds rate target range to 1-1.25% and the median dot plot continued to show three rate hikes in both 2017 and 2018. The post-meeting statement included modest upgrades to growth expectations, continued to note the fall in unemployment, but noted the moderation in job growth and the decline in inflation. The statement noted that the committee expects to begin the balance sheet normalization “this year”. The addenda to the statement provided additional guidance on the potential size of the “caps” for treasuries and MBS, which could rise from initial levels of $6bn and $4bn, respectively, to peak caps of $30bn and $20bn.

The Fed has a record of inertia and the current decision and signal reinforces the point. Recent economic data point to a slowing economy, not a serious slowdown, but a slowdown nonetheless. And yet, the Fed not only raised rates, which was probably an appropriate response, but maintained its rate trajectory expectations and was preparing the market for a normalization of its balance sheet. Inflation remains a bit of a mystery. Price pressures are only apparent in housing, healthcare and education with weak pricing almost everywhere else. A tight labour market warns that inflation may be around the corner, and yet a large number of people are neither employed nor unemployed, a data conundrum. The debt service imperative for the US government, whether Trump’s deficit plans are implemented or not, mean that there is limited appetite for much higher rates. We see rates as capped, at least, and perhaps even drifting lower. The USD curve which has flattened will likely flatten further.

Over the pond, the situation is a little bit different. The European economy is in fine fettle, despite the various political stumbling blocks. LREM’s landslide in the legislative elections this weekend only reduces political risk further. The ECB will be hard pressed to escalate QE, and will probably have to normalize policy around the same time the Fed begins to normalize its balance sheet. There is some risk in a concerted moderation of liquidity, however, we see central banks as hypersensitive to liquidity risk and expect that open market operations will over-compensate. The ECB’s position is tricky in that current policy will be inadequate either for Germany or for the periphery. It has either to deviate from the capital key, and anger the Germans, or substitute repo for outright asset purchases. It is likely that we will find some convergence between bund yields and US treasury yields over the coming year or years. We also see convergence in peripheral yields to bund yields. This has consequences for equities as funding costs in the periphery fall relative to Germany and France.

This week, we have focused our fixed income further into the market of US mortgages accessing more specifically the agency credit risk transfer securities market. The US housing sector is doing well, the houses, not so much the builders. Whereas in the past we focused on legacy non-agency RMBS, an ever decreasing market, we now expand our attention also to agency credit sensitive MBS. We also continue to be invested in European bank’s capital securities. The demise of Banco Popular was isolated to itself and a handful of Spanish banks’ tier 2 securities, as the market read the risks to be specific and not systemic.

It is interesting to note that YTD, while the S&P500 has returned 8.7%, the non-agency RMBS sector has returned 11%, and the CoCo market, 9.3% and both with less than half the volatility.

Week ahead:

Jun 21

  • BoJ minutes
  • UK PSNB

Jun 22

  • Europe consumer sentiment

Jun 23

  • Singapore CPI
  • France GDP
  • European manufacturing, services and composite PMIs