Five months into the year, the low equity volatility seen in 2017 already seems like
a distant memory. So far in 2018, the VIX has moved 5+ pts in a single day on four
separate occasions with the most recent coming on 5/29. Only 4 years have had more,
it’s still May. This higher equity volatility was finally joined by significantly higher rates
volatility as concerns about the new Italian government’s fiscal plans rocked the BTP
market and sent shockwaves through global fixed income. Indeed, the end of May saw
the Italian 2y move from -0.3% and touch as high as 2.85% in a single day. While this
VaR shock did serve to drive 10y Treasury yields to the lows of the month near 2.75%
temporarily, the rally was ultimately reversed somewhat to close the month at 2.85%.
VIX Index
Source: Bloomberg
Far and away the biggest global macro catalyst in May was the renewed anti-Euro
rhetoric from Italian populist parties who went as far as to discuss a potential
government debt write-down worth billions of euros. While these threats of
redenomination will likely end up idle, it was more than enough to scare holders of
Italian front-end paper out of positions and to the sideline, exacerbating what was
already a once in a lifetime move. As has been the case recently, the days following
this volatility spike saw the market revert back toward less stressed levels as leading
parties watered down their anti-EU rhetoric and backed away from calls for fresh
elections for now. Realistically, the threat of a new Italian election could hang over
that market indefinitely while the coalition partners look for the most opportune
time to go to the polls again. So this is not a problem that will somehow just
go away. While relative calm has been restored for now, the spread between 10y
German debt and 10y Italian debt remains at 2.42% after as being as wide as 2.88%.
As recently as April, this spread sat at 1.11% but now asset allocators are demanding over twice that yield pickup in order to take
on additional risk in form of Italian debt. With no clear, single path forward, this spread should continue to reflect the sum of the
probabilities of a euro-positive solution.
2 Year Italian Bond Yield
Source: Citi Velocity
Spread Between Italian and German Bonds
Source: Bloomberg
This most recent Italian populist flare ups couldn’t have come at a worse time for Mario Draghi and the ECB, which seemed primed
to proceed with an exit from extraordinary easing measures later this year. Now, central bank officials will be forced to debate the
merits of proceeding with a planned taper or waiting for more information on both incoming data and the Italian governmental
proceedings at their next meeting in June. Some market observers expect to see Draghi split the difference by moving forward with
the gradual taper as planned but being more explicit in forward guidance, reiterating that interest rate hikes will not emerge until
“well past the horizon of the net asset purchases.”
PSPP Country Breakdown
Source: ECB and Jefferies International
With European dysfunction sure to continue into the summer, the FOMC will be in a familiar position when they meet in June.
Despite solid U.S. data, any volatility from a flashpoint abroad would be an unwelcome development and coul complicate
FOMC hiking plans as has occurred in the past. To be sure, Chairman Powell may have a different reaction function than his predecessor but he will have to consider these additional factors nonetheless. None of the overseas events has risen to a
sufficient level to cause a change in the tightening schedule, according to the futures market, which now expects one tightening
in June and another in December.
As European events complicate American central bank
policy, American central bank policy has started to
complicate exchange and borrowing rates in emerging
market countries. After strong performance in 2017, the
JP Morgan EM Currency Index is now probing its 2015 low
as higher interest rates abroad exert downward pressure
on exchange rates. Notably, this pain pushed Urjit Patel,
Governor of the Reserve Bank of India, to write an op-ed in
a large U.S. periodical discouraging additional rate hikes. In
his view, since the U.S. central bank is tightening monetary
conditions and shrinking its balance sheet, it is creating
a global dollar shortage, which hurts emerging markets.
Judging by the sharp moves seen in EMFX this month, it
wouldn’t be a stretch to imagine Governor Patel isn’t alone
in his frustration.
JPM Emerging Market Currency Index
Source: JP Morgan
U.S. Treasury Market Overview
Source: Barclays Bloomberg
June is shaping up to be a month as full of meaningful macroeconomic catalysts as we’ve seen in some time and could go a long
way in setting the tone for the second half of the year. Not only will we have key central bank meetings in the U.S., UK, Eurozone,
and Japan we should get new developments on the U.S./N. Korea situation with a potential summit between leaders in early June.
Though summer months are thought of as a quieter time in the market, decreased volumes and watchfulness have often abetted
volatility shocks. In recent memory we have seen: Greek bailouts, CHN devaluations, and Bund VaR shocks all take place between
June and August. This summer could be similarly interesting.
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