There is no doubt that the upcoming ECB meeting will be the main event this week as investors anticipate that the European Central Bank will start discussing quantitative tightening.
The Federal Open Market Committee will gather next week as well. However, the feeling in the market is that the Fed meeting is a done deal: a 25bps rate hike and forecast showing further tightening and solid growth rate. However, there is also the eventuality that policy makers react to the latest political changes operated by Donald Trump, both on the domestic and international side. Indeed, the Federal Reserve carefully timed the start, as well as the pace, of its balance sheet unwinding with the objective of going unnoticed. It has worked pretty well so far as investors remained mostly focused on economic and geopolitical developments.
Inflation pressures have remained solid over the last few month - April’s CPI printed at 2.46% while the core measure increased to 2.14% - while the job market has never been in such a good shape. The unemployment rate eased to 3.8% in May, while wage growth accelerated slightly (+2.7%y/y) – even though on a real term basis, gains are less impressive.
Meanwhile, the Fed balance sheet shrunk by roughly $135bn to around $4.11tn, the lowest level since summer 2014. During the same period, the US 10-Year Treasury yield rose from 2.20% to 3.05%, while the 30-Year one hit 3.19%. It is difficult to know whether those increases in interest rates are exclusively due to the balance sheet reduction.
One thing is sure: the biggest buyer of US treasuries is slowly moving to the sidelines, which is reducing the supply of dollar. However, this phenomenon has been widely anticipated by market participants. What wasn’t expected is that Donald Trump took political decision that would result in an unexpected widening of the US deficit, which will ultimately translate into larger issuance of debt by the federal government. Against such a backdrop, it is not surprising to observe that emerging markets came under renewed pressure recently – since most of them are issuing debt denominated in USD. After all, the turmoil always starts at the fringe before moving slowly but surely to the core.
Even though we do not believe the FOMC will ring the alarm, we believe that members may mentions the global consequences of balance reduction, as well as the unfortunate concomitance of quantitative tightening and budget deficit widening.
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