European Political Concerns Spark Volatility

Broad market volatility was once again elevated in May. Long-end Treasury yields leaked higher in the middle of the month amid a stronger dollar and higher oil prices, with the 10-year yield reaching a 7-year high of 3.11%. However, in the last week of May, political concerns in Italy and, to a lesser extent, Spain sparked a global flight-to-quality trade that pushed the 10-year yield down 18 basis points (bps) to 2.75% (36 bps swing in just seven trading days). Italian 2-year bond yields surged 150 bps higher in just one day, bringing back fresh memories of the Eurozone debt crisis of 2011/2012. There remains a large amount of excess liquidity in European markets from the European Central Bank (ECB) though, and if we learned anything from recent crises, it’s the power of central bank liquidity in responding to short-term pockets of market volatility.

Nevertheless, if larger-scale credit concerns in Europe are overblown, there are growing questions regarding the viability of the current economic recovery in the region. Economic data have softened in Europe in recent weeks, particularly relative to expectations, and the European Economic Surprise Index has gone from a 7-year high beginning 2018 to a 6.5-year low in early May. With softer data, the EUR/USD exchange rate has fallen from 1.25 in early February to 1.15 more recently, and expectations for the ECB to begin reducing policy accommodation in the next 6-12 months have also diminished. The June 2019 Euribor contract has fallen 25 bps since early February as well and is closer to the current spot rate. In other words, the market has effectively unwound pricing for a June 2019 ECB rate hike.

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May At-A-Glance

• European political concerns in late May sparked rate volatility in the region not seen since the 2010-2012 Eurozone debt crisis
• The Fed is expected to move forward with a June rate hike, but the May FOMC minutes revealed an unexpected discussion of IOER
• Trade tensions moved back to the top of the headlines at the end of the month following a surprise decision from the White House
• The domestic data trend remains solid, including another strong jobs report in May

Over the last 12 months, we’ve discussed a less-accommodative ECB as perhaps the biggest headwind/wildcard for financial markets and the global economy. The ECB is still expected to end its current asset purchase program in September, unless fresh growth concerns and more tepid inflation readings surface in the coming months. If it appears that the ECB will maintain easy monetary policy for the foreseeable future, it should parlay into greater investor support for long-term government bond yields (not to mention MBS spreads).

This market overview is provided by ALM First Financial Advisors, LLC, the investment advisor for Trust for Credit Unions. Read more from ALM First about the latest economic data releases and overall market trends at Trustcu.com.