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Throughout most of last week, fixed income markets saw a marked increase in risk aversion as core government bonds rallied on the back of an escalation of geopolitical events in Ukraine and the Middle East. Peripheral European bond markets also recovered some of the lost ground in relation to core European government bonds as Portuguese concerns abated. Macro economic data surprised to the upside in the US and UK. Federal Reserve’s Yellen’s Senate Banking Committee testimony was broadly neutral as she recognised the recent improvement in the labour market. This week, the key data to focus on include key PMIs in Europe, Japan and the US, June CPI inflation in the US and Japan, Durable Goods Orders in the US and June ECB money supply data. In the UK, on Wednesday, the Minutes of the July Bank of England policy meeting will be released.
Meanwhile, the prospect for negative surprises in the eurozone is probably increasing, but investors need not be particularly concerned, for the time being that is. The Asset Quality Review (AQR) is likely to uncover a few small banks in need of some patching up and is expected to put some pressure on the front end of the curve, at least until banks access cheap funding via LTRO.
Recent events in Portugal’s banking system may be just a teaser for what’s to come, or maybe just a minor blip, but it clearly emphasises the lack of systemic risk compared historically and governments are in a better position now to raise money at cheaper levels, as the recent weakness in Portugal may be touted as a buying opportunity. In the long term, however, uncertainty remains and it implies that short dated peripherals are preferred to longer dated ones.
The full impact of the TLTRO announced last month may not be felt till Q115. Till then, there are a number of weak economic numbers which the markets might wish to scrutinise such as a slowdown in a handful of key European core economies. This, coupled with geo-political volatility could result in an increased rise in risk aversion and keep longer dated Eurozone yields anchored. This low yield environment could compel investors to extend their bond portfolios in terms of maturities and/or down the credit ladder in the continuous search for yield.
Across the Atlantic, although the decent US economic backdrop has not generated much volatility or gains in longer term US yields, shorter term yields have been grinding higher, with 2-year USD swap rates edging towards the 0.70% level, up from near 0.50% in late-May. This means that the gradual rise in shorter term yields is consistent with the better trend in the US economy as well as the progression of expectations on Fed policy. Markets now not only expect another USD10bn taper in monthly asset purchases to be announced at next week’s FOMC meeting, but the anticipated end of QE this October could also result in a culmination of the end of the Fed’s tightening cycle, expected by many by Q215.
Elsewhere, data released towards the end of last week indicated that the Chinese economy expanded 7.5% y-o-y and 2% q-o-q in Q214, well ahead of market expectations, as activity data suggest that most of the improvement came in June. Policy support from the current administration was instrumental in bringing about an earlier and stronger recovery. Bank lending picked up strongly in June whilst fiscal spending accelerated in May and June. This resulted in acceleration in infrastructure investment and related manufacturing investment.
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