Conflict, Weather, Pests and Inflation
In the first quarter, U.S. monetary policy, the conflict in the Ukraine, and recent developments in China have dominated the U.S. financial markets.
By Steve Van Order, Fixed Income Strategist
This year, three main issues have primarily moved U.S. financial markets: trends in U.S. economic data, the conflict in the Ukraine, and developments in Chinese fiscal and monetary policy. We can see there is a lot going on, yet reasonable uncertainty over outcomes is not reflected in the very low stock and bond price volatility levels. Maybe that's because of the offsetting nature of some of these influences, a sort of volatility strangle if you will. As a result, since February the benchmark ten-year T-note has been trapped in a narrow trading range from roughly 2.6% to 2.8%.
The trend in U.S. economic data has important implications for the path of monetary policy. The Fed is very U.S. data-dependent in its policy decisions. Negative U.S. data surprises appear to have bottomed. But while softer winter data and GDP growth should give way to a spring rebound, the strength of the rebound remains to be seen. For example, March housing data was surprisingly weak. Traders are waiting to see if the data upturn is going to materialize. In the meantime they can be distracted by the Ukraine and China.
As the old adage goes, war is inflationary—but for whom matters a lot. Conflict in the Ukraine has raised the risk of an energy price shock to Europe. This would have an adverse effect on euro area growth and cause the European Central Bank (ECB) to ease, perhaps using unorthodox measures, like bond purchases and quantitative easing. The risk of this scenario means the ten-year Treasury yield should continue to trade well-above German Bunds. However, if the ECB does ease and leans to do more, Bund yields may further sink, and Treasuries will want to follow. With the euro area economy still weak, it might not take much to derail that recovery.
Meanwhile, developments in China have the market's attention. China's fiscal and monetary policy responses have had an effect on currencies and China central bank reserves. By weakening the yuan, the central bank boosted China's foreign exchange reserves by $126 billion in Q1. The central bank has been diversifying away from the dollar toward the euro but that historically-wide Treasury/Bund yield spread mentioned above means the central bank might just favor Treasuries over Bunds which is a bullish influence for the U.S. bond market.
The market effect of these key issues, in addition to recently observed higher food prices, is of great interest. A bad citrus crop, pests in Florida, drought in Brazil, and an exceptional drought in the U.S. west has affected grain, meat, vegetable, and fruit prices. How might this affect the bond market? If the rise in food price inflation were seen to be dampening household consumption, then GDP forecasts would be downgraded. In this case, short-intermediate yields would move lower, while the long bond yield may move higher. Even though this scenario may seem unlikely, one has to take into account many possible scenarios that would make life quite interesting in Bondland. And this would be one of them.
This commentary represents the opinions of the author as of April 25, 2014 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information. Calvert may have acted upon this research prior to or immediately following publication. In addition, accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.