For most of 2016 U.S. high yield bonds returned plenteous profits to investors and led to reaching the 3rd best performance over a period of 20 years. While these markets were driving debt markets, mainly on an U.S. turn from an industrial recessional period and on low interest rates, the U.S. economy strengthened.
The market’s appetite for USDs arose after Trump won the U.S. elections in November 9 as promises over tax cuts allowed companies and public to believe liquidity was likely to expand. The Dollar surged along with the Dollar index, interest rates started increasing, and subsequently fear grew as Trump’s promises did not effectuate, yet. While interest rates continued to appreciate on major fiscal and policy reforms, U.S. Q2 2017 growth expanded an annualised 3%, its highest level since Q1 2015, albeit Q1 growth reached its lowest level since 2014. Meanwhile, demand for Dollars depreciated with the Dollar index showing heavy signs of weakness in July. Despite inflation did appreciate in Q1, and since the Dollar index guides inflation rates, it is likely that Q4 will reflect the decline in Q2, as median lag is ~4.5 months.
Unlike a few months back (currency clips Issue 76, pg 27), a crossover between the 10-2 Year treasury constant maturity and the Fed Funds rate did occur back in end-May/ start-June, while political and geopolitical risk, as well as fear increased. Simultaneously, bond markets rebounded in late Q2 and early Q3, and despite that the Fed raised short-term interest rates since, investors expect a subtle path to policy normalisation as tightening of liquidity is expected in Q4. September’s FOMC will provide more clues.
As of the beginning of Q3 U.S. Dollar declined over 3 ½% since the end of Q1 while Euro was fueled by Dollar’s weakness due to the appreciation in political risk. The decline was supported by an increase in the Eurozone’s political and economic confidence. With Euro reaching a 2-Year high few weeks back, ECB not rushing into tapering soon, and with the recent extension of the U.S. debt ceiling till December 15, the market appetite for U.S. Dollars is likely to experience wild swings. The latest unquestionably bad NFP is a proof of the market’s appetite.
With N.K conflict weighing in, uncertainty over another rate hike, and disastrous hurricanes that push USD lower, political and geopolitical tensions are likely to keep turning sentiment around and encourage price swings.