FTG Blog - Investors Scramble to Keep Pace With New Market Outlook

Investors Scramble to Keep Pace With New Market Outlook

For investors scrambling to keep pace with a hawkish shift in the world’s biggest central banks, the second half of 2017 just got a lot more interesting. Two weeks of rhetoric from policy makers in Europe and North America has rewritten the outlook for markets, with the Bank of England and the Bank of Canada now seen as more likely than not to join the Federal Reserve in raising rates before the year is out, based on overnight index swap rates. Even the possibility of a European Central Bank hike, once seen as all but impossible, is slowly growing.

The prospect of four of the world’s five largest central banks moving to tighten policy at the same time is shocking traders after years of easing, with the dislocations in money markets also rippling through global bonds.

“Bond markets have been conditioned to thinking that whenever there was a slip-up in risk appetite somewhere and a tightening in financial conditions, the central banks would come to their rescue,” said Mark Chandler, Toronto-based head of fixed-income strategy at RBC Capital Markets. “Now it’s almost as if the central banks are engineering the tightening in financial conditions. Does that mean more volatility? The sure answer would be yes.”

German 10-year yields climbed the most since 2015 while the euro had its best day since April on Tuesday as ECB President Mario Draghi said that reflationary forces had replaced deflationary ones in the region. Meanwhile two-year gilt yields reached the highest since June 2016 on Wednesday and the pound surged as Governor Mark Carney appeared to move closer to the hawks on his Monetary Policy Committee by saying it may need to begin removing stimulus.

Across the Atlantic, the yield on Canada’s two-year government bonds shot up above 1 percent for the first time since January 2015 on Wednesday and the loonie surged the most in over a year as BOC Governor Stephen Poloz reiterated the central bank may be considering higher rates. Swaps trading suggests investors are see a roughly 70 percent chance of a rate hike at the bank’s July 12 rate decision, up from about 40 percent Tuesday.

Even in the U.S., where inflation gauges have tumbled below the Federal Reserve’s 2 percent target, Chair Janet Yellen has reiterated that the central bank’s tightening is on track, keeping two-year Treasury yields close to an eight-year high. Policy makers came into the year expecting to raise rates three times. They’ve already hiked twice, and traders are pricing in better than 50 percent odds that they’ll stick to their plan and raise borrowing costs again before year-end.

While U.S. policy makers may continue to tighten, traders are ratcheting up their expectations for other central banks and paring their outlook for the Fed. That’s causing rate differentials between higher-yielding Treasuries and other sovereign bonds to narrow.

The yield spread between U.S. and Canadian 10-year debt fell to 58 basis points on Wednesday, the lowest since October. Compared with German bunds, Treasuries offer the smallest yield pickup since November. And the U.S.-U.K. 10-year yield differential, at 107 basis points, is the smallest since February.

“The trend in rates has been pretty much straight down throughout the first half of the year,” said Doug Porter, Toronto-based chief economist at Bank of Montreal. “That may reverse in the second” half.