Investors were clearly rattled by the mixed messages emanating from central banks in June, which sparked a sell-off in government bonds.
The Federal Reserve at least has been fairly clear about its direction of travel. It has struck a more hawkish rhetoric recently, as policy makers become increasingly confident on the outlook for the US economy. The Fed raised interest rates by a further 25 basis points in June – a move that was widely anticipated by markets – and spelled out a strategy for slimming down its balance sheet.
However, the European Central Bank and the Bank of England have both managed to send out conflicting signals in recent weeks. The minutes from the ECB’s June policy meeting were dovish enough but President Mario Draghi then appeared to signal he was preparing to taper the Bank’s bond-buying scheme.
Consequently, government bonds produced a negative performance in terms of total returns in June, with only the peripheral countries in the Eurozone putting in a positive performance. Greece and Portugal both delivered positive total returns but, in the case of the latter, this was primarily due to the success of the government bailout negotiations.
The Bank of England poured more fuel on the fire
The Bank of England also suffered from its share of communication problems. It elected to keep rates at the record low of 25 basis points but came closest to raising them in a decade. Three members of Monetary Policy Committee voted in favour of a rate rise, signalling the strongest support for a hike since 2007. Governor Mark Carney further muddied the waters by first saying it was not time for an interest rate hike, only to follow up with an assertion that it might be.
The Bank of England poured more fuel on the fire by announcing that it plans to increase capital requirements for UK lenders from June 2018. The Financial Policy Committee’s decision to tackle consumer credit risks and pave the way for Brexit uncertainty, only exacerbated the sell-off in gilts.
On the whole, investor demand still proved supportive of credit markets in June, in no small part helped by central banks’ corporate bond purchasing programmes. Credit spreads were tighter across the board and, although real returns sank under the weight of shifting government bond yields, excess returns were positive.
The high yield sectors in particular performed well, although the US high-yield index was basically flat in terms of credit spread performance. The recent slump in the oil price has been felt keenly in this area since energy companies comprise around 20% of the US high-yield bond index. UK and euro indices have much less exposure to the energy sector and so are generally less vulnerable to any volatility in the oil price.
The above article was first published by Charles Stanley on 6th July 2017