Insight Multi-Asset weekly update: Mario Draghi hints at more interest rate cuts

Market and economic review

Dovish central bank rhetoric sent government bond yields sharply lower as risk assets rally

Last week saw the European Central Bank (ECB) and the Federal Reserve (Fed) deliver major easing messages; this supported risk assets and led to government bond yields moving sharply lower. 

On Tuesday, some of the largest market moves of the week were seen after ECB President, Mario Draghi, spoke at the ECB forum in Sintra. He stated “in the absence of improvement … additional stimulus will be required”, Draghi followed this up by reiterating that further cuts to interest rates remain part of the ECB toolkit, and hinted that, although not the primary tool, restarting quantitative easing would be considered. Following these comments many European government bond yields set all-time lows with the French 10-year bond yield briefly moving negative for the first time. Risk markets reacted positively with European equities closing up c.2% on the day. Markets also priced a 10bps cut in rates by year-end.

Wednesday saw the Federal Open Market Committee meet where guidance for the July meeting was in focus;  market expectation had been building over the past month, with the probability of a rate cut at the July meeting moving from approximately 20% in May to 80% just prior to the Fed meeting. The message from Fed Chairman Jerome Powell, was more dovish than markets expected; the bottom line was that the Fed “will act as appropriate to sustain the expansion”, as opposed to being “patient” as mentioned in previous statements. Markets reacted positively with largest reaction seen in US Treasuries with the 10-year bond yield moving below 2% and the short end of the yield curve outperforming the long end with the US 2-year bond yield declining c.18 bps. In equities the S&P 500 hit an all-time high. The backdrop of falling yields and USD weakness was especially positive for emerging market assets over the week. The Fed is now widely expected to cut rates in its July meeting, with two additional cuts possible by year end.

Positive trade war sentiment builds as talks look set to resume at the G20 summit

On Tuesday, Trump tweeted that he had just had a “very good telephone conversation” with President Xi, confirming that there would be an extended meeting at the G20 summit at the end of next week. The statement was later substantiated by Chinese state media; further comments from Xi expressed a hope that the US will treat Chinese companies “fairly”. Markets reacted very positively with risk asset continuing to build momentum on an already positive tone from Mario Draghi’s statement shortly before. The US-China trade war has grown in significance in how it negatively effects growth, and therefore, how it impacts central bank policy.

In addition, tensions continued to flare with Iran; news sources suggested that retaliatory strikes were being considered following Iran’s shooting down of a US drone on Thursday. The price of Crude Oil (WTI) increased c.5.4% on the day following the escalation and dampened risk asset momentum on Friday.

Data releases were mixed on the week, serving as a reminder that the global economy is not in the clear

It was a fairly quiet week for data but Friday saw the releases of provisional June PMI data points out of Japan, the EU and the US. PMIs provide good leading indicators of global economic activity, which we are closely following given concerns of slowing global growth. The flash PMIs for June send mixed messages: manufacturing remains weak, services are holding up better, but ultimately forward expectations are dogged by trade war fears.

Japan saw a weaker manufacturing PMI of 49.5 (below 50 is contractionary territory) with its new orders component at a three-year low. The broader EU PMI data highlighted some divergence in growth between core and peripheral countries, suggesting growth stagnation in the latter. France saw a more positive data reading with an increase in its manufacturing PMI (52 vs. 50.6 last month), as did Germany (45.4 vs. 44.3), with some of the manufacturing sub components pointing to a bottoming in the recent weakness. Provisional June PMIs from the US were slightly weaker across manufacturing (50.1) and services (50.7), continuing to edge closer to contractionary territory. Trade-war worries continue to challenge the outlook; with subdued business confidence and business activity approaching stagnation in June.  

Outlook

Over the coming week we will get preliminary inflation readings for key countries in the eurozone including Germany, France and Italy, which could be informative in light of the ECB’s ongoing commitment to supportive monetary policy. On Friday we will get US PCE inflation, this will also be the first day of the two-day G20 summit in Osaka.

Additionally, we will be watching for signs of potential stabilisation in the latest German IFO (business climate indicator) reading which has been declining since October 2018.  Elsewhere in the US, preliminary durable goods orders could provide guidance on the likely strength of the domestic economy.  

By Adam Kibble, investment specialist, Insight Investment Australia