What are the implications of recent political events in Italy, deepening trade tensions and the June FOMC meeting?
After an eventful May for bond markets, Cedric Scholtes, Co-Head Inflation and Rates Committee Chair at BNP Paribas Asset Management, gives his views on US breakeven inflation rates, the possible risks from Italian political uncertainty and deepening trade tensions, and the implications of the June FOMC meeting.
Yes, in mid-May, we held the view that US breakeven inflation (BEI) rates would continue to rise. This view was based on the following arguments:
Given our baseline scenario that the FOMC will deliver more rate increases than is priced into the overnight indexed swap (OIS) curve, we also maintained a nominal curve flattening exposure.
From a technical perspective, we nevertheless recognised that 2.25% was an important technical resistance level for 10-year US BEI rates, and that a catalyst would likely be required to push 01/2028 BEIs through and above that level to a target of 2.40%. That catalyst would ideally be stronger wage data and/or core consumer price index (CPI) data.
We identified several possible scenarios with the potential to jeopardise our view that BEI rates would rise:
The primary downside risks to our long BEI position was clearly that the formation of an Italian government from a coalition of 5-Star and League would trigger a market stress episode, on concerns about the fiscal implications and the possible consequences for the eurozone.
Investor concerns on Italy have at least temporarily receded somewhat following assurances by Italian finance minister Tria and European Affairs minister Savona that the Italian administration has no plans to exit the eurozone.
Nevertheless, we remain concerned that the administration will, in due course, put forward fiscal proposals that breach European Union budget deficit rules, initiating a confrontation with the European Commission, and validating investor concerns over the Italian Treasury’s long-term fiscal sustainability.
In other words, we continue to see an obvious inconsistency between assurances that Italy will avoid measures that might lead to an exit from the eurozone and its stated fiscal agenda. Rome’s budget proposals will likely be delivered to Brussels in September or early October, so we anticipate market stress could well return as policy details emerge.
For the time being, however, soothing words and net redemptions on outstanding Italian government debt are likely to keep yields of Italian sovereign bonds contained.
In early June we were treated to a display of Trump-style US diplomacy at the G7 meetings in Quebec. The US administration’s refusal to sign the communiqué and its treatment of its EU and NAFTA partners have significantly raised the odds of an escalation of trade conflict, with US tariffs being met with retaliatory measures.
Furthermore, recent press reports suggest the administration will proceed with proposals to apply tariffs to Chinese goods, which will, again, be met with swift retaliatory measures. If enacted, these tariffs would likely be supportive for short-dated BEIs and could be supportive for sovereign bond markets via the adverse impact on growth and economic confidence.
This meeting of the FOMC provided some revelations that clarify the Fed’s intentions:
In my view, the implications of the June FOMC meeting are as follows:
Here’s what I take away from what’s happened:
US core CPI inflation data for May was disappointing, even though recent average hourly earnings numbers were more robust. This means we are still waiting for a catalyst for further BEI widening.
The renewed potential for tariffs, along with a more hawkish FOMC, means there is more scope for a rise in short-dated BEIs than long-dated BEIs.
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