- The European Central Bank (ECB) did not give any guidance on 08/09/16 as to what will happen when its quantitative easing program ends in March 2017, sparking the beginning of a sustained sell-off in yields.
- The Federal Reserve may not raise rates at the meeting on 20-21/09/16, but the chances of a rate hike have risen markedly.
- A complacent market seems to have been unprepared for either of these events and we are left to wonder whether that adjustment has now taken place, or if the sell-off in bond markets that began on 09/09/16 is a sign of things to come.
The summer of 2016 may be remembered for a successful Olympics in Rio de Janeiro, for Brexit, for a colorful US election campaign, and for a wave of terrorist attacks in Europe and the Middle East. We know that events that seem so important in the day-to-day are often lost to history, and conversely those ignored at the time can prove to be much more significant with hindsight.
Even with this caveat, those choosing to take much of August off missed almost nothing of consequence in markets, with time on the beach and trips to gelaterie. Measures such as the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) of the Standard & Poor’s 500 Index (S&P 500) options volatility, a proxy for market risk more generally, registered their lowest sustained period of volatility in more than 10 years. That was then.
On Thursday, September 8th, the market reaction to the European Central Bank’s (ECB) announcement that it would not be increasing the amount of its stimulus or further cutting interest rates, sparked the beginning of a sustained sell-off in yields. German 10-year Bunds are now yielding a positive interest rate, and US 10-year Notes rising by 14 basis points over two days.
While the ECB’s announcement had not been a surprise, there was evidently some disappointment at ECB President Mario Draghi’s downplaying of the need to make additional purchases given that the quantitative easing program is scheduled to end in March 2017. This reflected first the lack of volatility in August, but more materially that the program itself may need tweaking. Morgan Stanley published research estimating that EUR 467 billion of investment-grade European corporate bonds are yielding less than zero, equating to 33% of those eligible for the corporate sector purchase program (CSPP).
Investors are still also weighing the possibility of an interest hike from the Federal Reserve to be announced at its meeting on 21 September. At time of writing, the market is giving a 24% chance that the Fed will hike. This is still low but given that it was effectively zero in July, it represents a marked shift.
For December, the probabilities approach 50/50. The Bank of Japan (BOJ) also meets on 21 September, and while there is a suggestion that the BOJ is trying to work out how best to steepen the yield curve, Japan has serially disappointed those looking for stronger policy action.
Given this rampant degree of complacency, it is not surprising that the market was vulnerable, and after largely ignoring bond moves on Thursday 8 September, risky assets performed poorly on Friday 9 September. The S&P 500 had not had a move greater than 1% since early July, and had its worst day since the Brexit referendum, falling 2.54%. This has also been illustrated across emerging markets and credit indices, though with less intensity than stocks.
The question is whether this fall represents an ongoing vulnerability, as markets digest the limits of quantitative easing, even as that easing drives lower yields and higher stock multiples, or whether it represents something of a small correction in markets which had ceased to price any possibility of a change in Central Bank policy. Price action on Monday 12 September suggests more of the latter, but central bank policy is likely to change, and at the margin, to reduce liquidity. Whether the market views this as effectively good news stemming from a stronger economy or a policy mistake set to make an already fragile economy weaker remains to be seen.
Exhibit 1: Pricing in financial markets currently (as of 12/09/16) imply a 24% probability to the chances of the Federal Reserve hiking the US Fed funds rate from 0.25% to 0.50% at the policy meeting on September 21 2016. The graph below shows how market pricing for a rate hike has evolved this year.
Back in early July markets saw a zero % probability of a rate hike, over the summer this has risen to 24%, still low but nonetheless a marked shift in sentiment.
Source: Bloomberg as of 12/09/16 [divider] [/divider]
This article was written by Alex Johnson, Head of Absolute Return Multi-Sector Fixed Income, on 13 September 2016 in New York