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July 2019 Fixed Income Market Update

Economic and market perspective

Shifting expectations around monetary policy globally, and trade tensions dominated market news in June.

The tariffs that President Trump announced on all imports from Mexico at the end of May were scuttled before implementation as Mexico agreed to institute more stringent border security. The threat of those tariffs had impacted risk-off sentiment at the end of May and their negation improved sentiment when announced in June. Mexico also officially ratified the United States-Mexico-Canada Agreement (USMCA) in June. In doing so, Mexico became the first country to formally agree to the trade deal negotiated to replace NAFTA.

Unlike with Mexico, trade tensions with China persisted through the month. In reference to a trade deal with China, Treasury Secretary Steven Mnuchin raised hopes of a resolution when he said that “we were about 90% of the way there and I think there’s a path to complete this.” Over the final weekend of the month at the G-20 summit in Japan, President Trump and President Xi of China agreed not to impose new tariffs and to restart trade talks; part of the arrangement allows Huawei to resume buying from U.S. companies.

Two oil tankers were attacked in June in the Gulf of Oman. The United States believes that Iran is responsible for the attacks. Further, Iran shot down a U.S. drone in June, prompting additional fears of expanding Middle East tensions. Reports indicated that President Trump initially authorized a retaliatory strike before rescinding the order. Instead, the U.S. instituted further economic sanctions on top of already existing sanctions and reportedly engaged in cyber attacks against Iran. In part due to fears of escalation in the Middle East, oil prices rose almost 10% in in June, from $53 a barrel to nearly $59 a barrel.

Mario Draghi, President of the European Central Bank (ECB), suggested that the ECB could further ease policy if the economic outlook in Europe did not improve. Later in June, Euro-area core inflation was reported and rose only 1.1% for the month, enhancing expectations that the ECB would cut rates. Current expectations are for a rate cut at the ECB’s September meeting. The ECB’s next meeting is on July 25 and will be closely monitored for additional indications on forthcoming policy changes.

The Federal Open Market Committee met June 18 – 19 with markets expecting no policy change, but looking for indications regarding the July 30-31 meeting. As expected, the Fed did not adjust the Fed Funds rate, but hinted at shifting policy looking forward. The Fed removed the word “patient”, which it had used to characterize its stance on policy normalization, and replaced it with a perspective that it would “closely monitor” developments; this is seen as a lean towards future rate cuts. The Fed’s dot plot, which captures Fed governors’ views of future Fed Funds Rates, showed a meaningful shift downward of individual expectations of future rates, but due to the preponderance of those expecting rates in the current range of 2.25 – 2.50% there was no change in the median.

In the press conference after the minutes were released, Fed Chairman Powell referred to the Fed’s “one overarching goal: to sustain the economic expansion.” In response to a question, the Chairman responded that “in a world where you are closer to the effective lower bound…it’s wise to react, for example, to prevent a weakening from turning into a prolonged weakening. In other words, sort of, an ounce of prevention is worth a pound of cure.” This response, the general tone of the meeting and subsequent Fed member speeches have reinforced market expectations of a rate cut coming soon. As of the end of June, Fed Funds futures anticipate a 100% probability of a rate cut at the July meeting with approximately a 25% chance of a 50 basis points cut.

Outlook and conclusions

In our view, given the Fed’s reluctance to disappoint markets, absent a compelling positive development on trade (unlikely) or economic data (possible), the Fed will likely deliver the rate cut the market expects in July. In this repositioning, the Fed has pulled the range for longer interest rates lower. While we have believed that U.S. economic data would remain more resilient than feared, which to-date has been the case, this has not translated to the U.S. rates market largely due to the Fed’s actions. We expect the Fed’s repositioning to accommodation to support credit going forward. However, we would not argue that credit is cheap given the current landscape and we are cautious that future volatility is underpriced. With the move lower in rates and tighter in spreads, fixed income delivered stronger returns than what most would have expected in the first half of 2019. It is unlikely the second half will offer similar returns, though a newly accommodative Fed and reasonable fundamentals are likely to support the asset class looking forward.

Originally Posted on July 1, 2019 – July 2019 Fixed Income Market Update

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