Risk assets got a further boost this week from the continued dovish tone from Fed showing that the punch bowl will not be taken away any time soon – see Flash Comment: Fed statement balanced – but rate projections are moving higher. The market and us was expecting a slight hawkish change in tone given the recent higher core inflation data, but the Fed kept the statement broadly unchanged instead.
This leaves the mix of very accommodative monetary policy and strengthening recovery in place, which is an optimal mix for risk assets. The market ignored the fact that the Fed revised higher their median projection for the Fed funds rate at the end of 2016 for the second time in six months. The end-2016 rate projection is now 2.5% up from 2.25% in March and 2.0% in December. Instead focus was on a still soft tone on inflation and a downward revision of the long term Fed funds rate from 4.0% to 3.75%.
Carry is king, until it’s not
Bond yields fell back on the back of the Fed message despite the fact that by the end of 2016 the market is now having a gap of 70bp to the Fed projection as the futures curve only price a rate of 1.80%. The rise in money market rates and short end yields seems to lure back carry trades – especially since the carry in the US has gotten better relative to the euro area, where yields have been pushed lower following the dovish message from the Fed recently. The low for long trade has been popular for a long time and investors are quick to buy short end bonds on spikes in yield.
Eventually, though, we believe the market will have a reality check and bond yields will likely rise to get more aligned with what Fed is actually projecting. Carry can only beat fundamentals for so long. Continued falling unemployment and gradual rise in core inflation will make it hard for the Fed to keep the current dovish tone and they may also fear that if they keep the dovish tone for too long, the market will get a shock when they eventually change it. This was the mistake when they announced tapering in May last year which led to the marked sell-off in the bond market. The balance for the Fed will be to change their tone more gradually in order to avoid to much volatility.
Peripheral bond yields have seen some correction higher this week but it should be seen in the light of the very strong performance following the ECB meeting. We are seeing a bit more volatility in the spreads now as the risk/reward is less attractive and it seems investors are faster to take profit on rallies. Overall we still believe, that peripherals will be supported from stronger fundamentals and search for yield and expect the downward trend in spreads to continue.
EUR/USD decline takes a breather but downward trend intact
The soft Fed message also led to a rebound in EUR/USD breaking the recent downward trend. Three factors are likely behind the move: 1) US short yields fell relative to euro yields following the Fed meeting, 2) hot money has become very short the euro now.
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