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PATRIS Fixed Income- 6 July 2018

6 Jul 2018

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1. The minutes of the June FOMC meeting showed rising concerns, namely around trade policy, emerging markets and Europe. The Minutes noted an upbeat view on the growth outlook. Most participants viewed fiscal policy as a support to economic activity. Participants indicated that core and headline inflation moved close to 2%, in an environment with increasing supply concerns. Participants said that it would be appropriate to continue gradually rising the federal funds rate.

2. Despite numerous concerns, such as trade fears, Italian politics, growth slowdown and EM stress, the downward move on 10-year UST yields has been relatively restrained. If the overheated US economy and rising inflation continue to force the FOMC to hike interest rates, US bonds are likely to remain vulnerable.

3. ECB rates expectations have recently moved upwards, after press reports that some ECB policy makers are uneasy that markets are not pricing an interest rate hike until the end of next year. However, rates expectations remain clearly dovish, reflecting fears around an escalation in the trade war, the slower pace of economic expansion in the euro area and the enhanced forward guidance on interest rates that came out of June's ECB monetary policy meeting. The ECB outlook on medium-term inflation should remain key.

4. ECB chief economist Peter Praet confirmed that date-based and state-contingent forward guidance has become the main policy tool for adjusting the monetary policy stance in the future. He added that significant stimulus is still needed for the continued convergence of inflation. Therefore, as more information becomes available in coming quarters, the ECB will probably guide the market if they see a significant gap between the Governing Council's outlook and investors' expectations.

5. Investors remain cautious on Italy. Tensions with the European Commission are likely to rise over coming months, as we near the 2019 budget discussions. At the end of the day, markets will probably determine the size of fiscal stimulus that the Italian government will be able to deliver. Fiscal stimulus should be delivered in a sequential way, as the Lega and 5 Setlle soften their stance on public finance management and take a pragmatic approach.

6. 10-year Bund yields moved lower over the last few weeks on risk-aversion. At currents levels, Bunds could be vulnerable, in particular to improved macro news flow, while the economic surprise index for the eurozone is already recovering from its recent lows. However, the ECB dovish stance and potential for additional negative headlines on trade policy could continue to limit any sharp rise in rates.

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