Geopolitical risks send government yields to record lows

Good morning!

Notwithstanding that the ECB and BOE monetary policy meetings took place yesterday, the markets were more concerned with the geopolitical developments which are now a more important source of surprises. The situation is escalating at both risk centres with Russia imposing food import bans to respond to the West’s decisions and US authorizing air strikes in Iraq. Moreover, Reuters quoted a top U.S. Treasury Department official as saying that the US stands ready to impose additional sanctions and warned against any food-for-oil agreement between Russia and Iran.

Bloomberg reported that Finland is particularly vulnerable to the food import embargo but at a European level the effects appear limited given that a large share of the food imports come from Latin America and Asia; for this reason, the Brazilian food processors could see an increase in demand. Nevertheless, the decision is still likely to hurt European business sentiment and increase uncertainty, both of which are detrimental for growth and investment trends. Indeed, the ECB’s Governor pointed yesterday that “heightened geopolitical risks, as well as developments in emerging-market economies and global financial markets, may have the potential to affect economic conditions negatively”. This is also likely to complicate the monetary policy decisions and to increase the difficulty of assessing how effective the latest ECB measures are for the longer term. Meanwhile, Draghi said that “the Governing Council is unanimous in its commitment to use unconventional policy measures like ABS purchases, like QE, if our medium-term outlook for inflation were to change” and that “we will closely monitor the possible repercussions of heightened geopolitical risks and exchange-rate developments.”

In this context, the stock markets weakened and the safer assets gained ground. Actually, the German bond yields dropped closer to 1%, marking another record, while the 2 year rate slipped into the negative territory; other European peers, such as Austria, Finland, Holland or France also joined the rally to the record lows. In the US, the 10 year yield is now below 2.4%, the lowest level in a year; of note, the latter gained ground even as the weekly unemployment claims bet expectations again and the four-weeks moving average now moved to the lowest in 8 years. Although the retreat in yields is beneficial for fixed income returns, the general backdrop is detrimental for spreads, with the lower rated bonds more susceptible to losses. This is particularly true for the US market where the monetary policy outlook adds to the downside risks. As such, the US high yields funds closed on August 6th a third week of strongly negative net flows; according to Bloomberg, the outflows were as high as USD7.1 billion, a record figure. Thus it is clear that the risk aversion is increasing in this environment marked by political events which are starting to cause obvious economic costs.

Even though emerging market suffered from the deteriorating sentiment, Chinese equities turned course after data showed that the country logged a record trade surplus, on he back of stronger exports growth and falling imports. Elsewhere in the emerging market space, the media reported that a deal might be reached with respect to the Argentian bond stalemate. Specifically, a group of international banks (Citigroup, JP Morgan, HSBC and Deutsche Bank) are reportedly close to reaching an agreement with holdout investors to buy their bonds for 80 cents per dollar.

In addition to the geopolitical developments, today the investors will have to digest the new earnings releases due, the below expectations German trade data that came out this morning and, later in the day, the US productivity gains and the labour costs changes.

Have a nice day!

Raluca