August Rates Update

Monthly Commentary

September 05, 2017

Traditionally, August is the least attended month of trading. With little impetus for price takers to enter new positions or take on additional risk, asset markets can fall into liquidity vortexes where slight buying or selling pressures move prices violently. This August was no different than years prior as the S&P 500 saw two separate 1% daily drawdowns but finished less than half a percent lower for the month. There is little doubt that ongoing North Korean saber rattling and fears about stretched equity valuations did indeed play a role in this weakness but with so few shares actually exchanging hands it is difficult to distill the true impact of the news on price. Unlike equities, which were characterized by twoway price action, US Treasury yields started their move lower at the onset of the month and never looked back. The back end of the Treasury curve led the way with 10y yields falling from 2.30% all the way to 2.12% as the spread between 2y and 10y Treasuries fell to 80bps.

U.S. Treasury Market Overview

Source: Bloomberg

In August, global macro developments were few and far between, with the symposium on monetary policy at Jackson Hole Wyoming, hosted by the Kansas City Fed, the lone focal point for the month. Presentations were kicked off by Fed Chair Yellen whose speech focused on past and prospective regulatory reforms but offered nothing in terms of a monetary policy outlook or her view on current risks to financial stability. Instead of talking about the current state of U.S. monetary policy she opted instead to discuss her view that increased regulation since the financial crisis has made the system safer without any impediment to growth and that any adjustments to regulation “should be modest”. That notion runs counter to the approach of the current administration, which could indicate Yellen is preparing to walk off into the sunset at the end of her term instead of continuing to conduct policy under the new administration.

Though the chair did not give market participants much to go on in terms of the future path of policy, what she didn’t say may be just as important. Given the recent focus from the FOMC on what it views as excessively loose financial conditions, Chair Yellen’s decision not to further the conversation on that topic suggests that she does not currently view the recent appreciation of risk assets to be overly concerning at this time. The market took the chair’s silence on policy as a dovish indication and further reduced the market-implied probability of a tightening at the December meeting down to a 1 in 3 chance.

Following Yellen’s lead, ECB President Mario Draghi declined to offer any fresh insight into ECB policy when he took the podium for the final speech of the first day of the Jackson Hole event. As expected, his comments were more focused on this year’s theme of “fostering a dynamic global economy” and voiced his support for sustaining openness in the global economy. Unlike the Fed chair, President Draghi did make at least once reference to monetary policy when he argued that financial regulation had prevented a long period of low interest rates from having adverse side effects for financial stability. While his defense of ECB QE is understandable, it did not give investors the clues they were hoping for about the future of Eurozone monetary policy.

Now that the ECB has taken its first steps toward the policy easing exit, the monetary authority has e found itself in a similar feedback loop as the one experienced by the FOMC in 2015 up until the initiation of their hiking cycle. As market participants prepare for the removal of accommodation, the respective currency appreciates in anticipation of tighter policy; the strong currency then acts as a drag on domestic inflation and potentially on risk asset prices and removes scope for the central bank to tighten. Thus far, the ECB has merely tried to float trial balloons through media backchannels to attempt to arrest currency appreciation. .It will be interesting to see if the ECB decides to step up its efforts in the coming weeks or months in the era of the tail wagging the dog. The ECB’s next opportunity to comment on the path of policy for the rest of 2017 will come at the conclusion of the September 7th policy meeting at which time the central bank will release updated staff projections and President Draghi will address the media. While no policy changes are expected next month, some believe President Draghi will begin signaling that the ECB is prepared to taper its asset purchase program sometime in 2018.

As summer draws to a close, the period of relative calm is almost unanimously expected to subside and give way to significantly more volatile market conditions. With the ECB and FOMC both scrambling for the exit from accommodative policy, the 19th National Party Congress to be convened in China, ongoing Brexit negotiations in Europe and the risk of an errant tweet in the U.S., this fall with be full of event risk. It remains to be seen whether or not this plethora of event risks eventually produces a downside catalyst for the price of risk assets. Given the forward looking nature of market pricing, all upside and downside risks for the rest of the year should already be included in current pricing. We will find out if they are.

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