The quite well anticipated, although more aggressive than expected, easing from the European Central Bank (ECB), followed by the US Federal Reserve’s more surprising lowering of its expectation ‘dots’, proved supportive for risk assets as the first quarter of 2016 ended.
Although the quarter was volatile, fundamentally the changes have not been that significant, with both negatives and positives almost matching each other, as pessimism about economic growth has grown. This volatility, although perhaps diminished for now, will probably rise again as markets grapple with the conflicting forces of high valuations, meagre economic growth and plenty of easy money.
There has been little uplifting news about the world’s economic growth, but nor has there been much to shock to the downside. Global growth is on course to achieve over 2.5% in 2016, similar to last year and still below its 3% long-term average. The Chinese economy is struggling, although anxieties about Chinese plans for its currency appear to have abated. US economic growth remains positive but feeble, while growth within Europe is decidedly patchy.
The more dovish stance from the Fed did significantly alter market calculations about the number of rate hikes likely in 2016, although most are still convinced that hikes will come. Inflation in the US is clearly rising, and Fed Chair, Janet Yellen, acknowledged that core inflation had risen “somewhat more” than she had expected. However, she was careful to emphasise her cautious outlook for the US economy considering the economic uncertainties in the world.
Whether the first rate hike will come in June is unclear; it is possible the Fed might prefer to wait until after UK’s Brexit referendum on 23 June as market nerves intensify in the run-up to the increasingly uncertain result.
Unlike many risk assets, such as credit which ended the volatile quarter reasonably close to where it began, risk-free developed market government yields fell markedly as they took on board the gloomier economic outlook and the more dovish stance of the central banks. Both US and Bund 10-year yields declined some 50bps, while the 30-year Bund took the honours with a remarkable fall of 66bps over the period, significantly flattening the Bund curve.
While there may be other factors at work driving risk-free rates, it seems likely that the ‘scarcity’ premium within German government bonds is a significant influence. Investors were hoping that Mario Draghi, the ECB president, would try to assuage their concerns by referring to the topic at its March meeting.
The ECB might have announced that it was relaxing a couple of its rules constraining asset purchases. These could have included allowing the purchase of fewer Bunds and buying more French, Spanish and Italian bonds instead, or permitting the purchase of some shorter-dated Bunds despite their yields being below the ECB’s threshold. However, there was no news on this front accompanying the ECB decision to increase the pace of asset purchase, and so it appears the scarcity problem has been exacerbated.
Inflation, so often the key focus for bond investors, is interesting just now. For several years central banks have fought strong disinflationary forces, desperate to keep deflation at bay, a battle they have not been winning. Indeed, inflation expectations have again been falling, with the five-year, five year forward breakevens in both the US and Europe falling 20bps this year alone (and significantly more in Japan).
However, although forward breakevens may have declined, core inflation in the US has trended higher for the last year at least. And there are some inflation bulls who discount the recent falls in inflation expectations and argue that inflation risk – in the US – is on the rise. They suggest that transitory effects, such as the dramatic falls in commodity prices, account for much of the recent falls in expectations and that wage pressures in the tightening labour market are going to rise, pushing inflation higher.
Although it was difficult to pick through last quarter’s financial market gyrations and find any sort of theme, is it now time to ask whether the dollar bull market is nearing, or has already reached, its end?
The first quarter of 2016 was a record one for the dollar index, beginning the quarter with one of the largest gains in 25 years and then, just a few weeks later, recording one of its most aggressive sell-offs and by the end of March it was down significantly on the year to date.
The Fed’s surprisingly dovish declarations have surely changed the near-term outlook for the dollar versus other currencies, and the forwards are definitely pricing a postponed and less aggressive tightening cycle. It is also the case that less upward pressure on the dollar means less downward pressure – and fewer capital outflows – for the Chinese currency. Thus China may be able to maintain its ‘impossible trinity’* for a little longer.
Carry trades could also be safer for longer, as the Fed takes a step back from its tightening schedule, and markets can continue their search for yield and possibly increase their appetites for risk too.
Emerging market currencies generally had a strong first quarter and, with an improved global risk appetite coupled with less chance of the dollar resuming its upward trajectory in the near term, some may continue to do well.
However, the majority view seems to be that the dollar’s pause is temporary and that in the coming months its bull run will restart, once again driven by the same factors of a strengthening US economy, tightening US monetary policy and China’s continued economic weakness.
*The impossible trinity, sometimes referred to as the trilemma, describes a central bank’s unachievable quest to run a flexible monetary policy and a fixed exchange rate and have freely flowing capital; only two of the three can be met at any one time.
Focus: Oil and risk assets
The correlation between risk assets and the oil price has been clear and unusually high over the past year. This has given rise to several important questions for investors. These include how long this close pattern might last and whether it is the oil price driving asset prices or if both oil and risk assets are together being influenced by some other forces.
Oil has long been an important commodity and its price matters greatly for industry, consumers, policymakers, politicians and asset managers. Although often volatile, analysts have always sought to identify a prevailing equilibrium price.
Today, that analysis appears to be more complicated than ever. Heightened tensions in the Middle East or in Nigeria, for example, create significant and often unpredictable supply disruptions, although they may encourage other old producers to pump more. There is also far more trading of oil on financial exchanges, with open interest at record highs, which is doubtless adding to increased oil price volatility.
The shale revolution has dramatically altered the supply dynamics of the global oil market. Shale oil producers, with smaller ‘fields’, tend to be more sensitive to movements in the oil price than are conventional oilfield producers. Thus, fluctuations in the supply of shale oil are likely to be amplified if the oil price is moving around.
Because it is difficult to reconcile changes across equity or credit markets with just a move in the oil price, logic suggests there are other interconnected forces at work, such as the Chinese economy or Fed statements, influencing oil and risk appetites together.
Perhaps only hindsight can deliver a workable explanation for why oil prices should be moving in close tandem with risk assets.