YIELDS RESUME CLIMB
SUMMARY OF MARKETS
The 6%+ one-day rally in the S&P 500 just one week ago – on the Friday before Memorial Day (May 27th) – now seems like a distant memory as stocks were clobbered on Friday following the release of a strong US jobs report for May. We are now back to the unusual relationship of positive correlation between bonds and stocks, as the prices of both moved lower this week. The “safe haven” bid that benefitted USTs for much of May has now again given way to recurring concerns about inflation and the Federal Reserve’s difficult task of navigating a “soft landing.”
In spite of weakness in US equities, global equity indices in Asia and the emerging markets delivered solid returns this week. However, the European bourses followed US equities lower. The S&P 500 was the worst performing global index I track (down 1.2% WoW), and the Nikkei 225 (Japan) was the best (up 3.7% WoW). Chinese equities have also bounced nicely, recovering steadily from their late April lows. The SSE Composite (Shanghai) closed 2.1% higher for the week and has risen 5.0% in the last month as COVID-related shutdowns seem to be subsiding.
Amongst US equity indices – all of which were down for the week – the value/small cap Russell 2000 had the least negative return (-0.3% WoW), and the S&P 500 had the worst (-1.2% WoW). The VIX is struggling to get back below 25, as volatility remains elevated Stateside, and investors remain nervous for a variety of reasons.
The US Treasury yield curve moved wider across the entire maturity spectrum, with 2- and 10-year UST yields higher by 19bps (2.66% close) and 22bps WoW (2.96%), respectively. The culprits were a strong US jobs report for May and the beginning of quantitative tightening by the Federal Reserve as it begins the process of reducing its balance sheet.
Yields were higher in the investment grade and high yield indices I track, as corporate bonds could not dodge the sharp increase in UST yields even though credit spreads narrowed by a few basis points.
As far as other assets, WTI crude oil was higher this week (+4.5% WoW) in spite of an OPEC+ agreement to increase production starting in July. The US Dollar also re-strengthened, acknowledging the strong US economy and the resumption of upward pressure on UST yields. The Yen was weaker, gold was flat, and Bitcoin was slightly stronger (+3.8% WoW).
ECONOMIC AND GEOPOLITICAL NEWS THAT MATTERED THIS WEEK
US jobs: Nonfarm payrolls for May – released on Friday – surprised on the upside,. The US added 390,000 new jobs in May (vs consensus expectation of 318,000 according to Bloomberg), the labour participation rate increased slightly, and unemployment remained at 3.6%. The number of unemployed Americans is 6 million, compared to 5.7 million prior to the pandemic. The strong data put further pressure on UST yields as inflationary expectations have returned to the forefront. You can find the May nonfarm payrolls report from the BLS here.
Federal Reserve balance sheet reduction: The Federal Reserve officially began reducing its $8.9 trillion balance sheet on June 1st by limiting the refinancing of securities held on its balance sheet as these securities mature. The aggregate monthly cap of reductions from June to September will be $47.5 bln / month, with sub-limits of $30 bln for USTs and $17.5 bln for MBS. After September, the monthly cap on reductions will double to $95 bln / month through the end of December. The FOMC minutes from the meeting on May 3-4 cover this well, and you can find the discussion and methodology for balance sheet reduction starting on page 10 of the minutes apply entitled: “PLANS FOR REDUCING THE SIZE OF THE FEDERAL RESERVE’S BALANCE SHEET”.
OPEC+ meeting: OPEC and non-OPEC members agreed on June 2nd to accelerate the increase in its production quotas starting in July to address higher global oil prices and offset some of the global supply lost to western sanctions on Russian oil & gas. The brief OPEC press release is here.
Eurozone inflation: Flash indications from Eurostat (here) showed that inflation (CPI) in the Eurozone for May rose to 8.1%/annum, well above consensus expectations (7.7%/annum) and April CPI (7.4%/annum). This data is underlying the increasing hawkish rhetoric from ECB members and its President Christine Lagarde as the ECB will have no choice but to soon jump on the bandwagon and lift bank borrowing / deposit rates to address rising inflation in the common currency bloc. I highlighted this last week, but in case you missed it, Ms Lagarde’s blog post from May 23rd is worth a read: “Monetary policy normalisation in the euro area”.
Sanctions on Russia: The EU officially approved its sixth round of sanctions on Russia on Thursday, including restrictions on gradually reducing the shipment of Russian oil by sea and cutting off state-owned Russian bank Sberbank from the SWIFT payment system. These sanctions were initially announced in early May. You can find European Commission President von der Leyen’s May 24th speech at The World Economic Forum (in Davos) discussing the EU view on Russia’s invasion here.
UK business confidence: UK business confidence rose for the first time in three months, according to Lloyd’s Bank Business Barometer. See “Business confidence increases despite signs of retail slowdown”. The UK government is looking for any good news it can find as the economy struggles.
WHAT’S NEXT?
I said last week that we were in an environment where UST prices might reflect fair value. This week showed that we are not there yet, as yields widened sharply off the back of ongoing inflationary concerns and the “full employment” status of the US labour market. With a red hot US economy, the Fed is on a mission to tighten monetary policy quickly to address inflation, and this – alongside higher global oil prices – is almost certain to push US unemployment higher and slow the economy. The US stock market does not like that generally, and of course the higher volatility names also do not like higher UST yields. Multinational companies based in the US are also starting to feel the effects of the stronger USD on future earnings, which Microsoft (MSFT) highlighted on Thursday in its 8-K filing that revised down this quarter's guidance (here). Mix this together and you inevitably have a cocktail for continued turbulence in markets. Perhaps the only good news for global equities is that concerns about COVID-related shutdowns in China seem to have eased, and perhaps Chinese equities – now arguably “more investible” – will continue to slowly ascend.
As far as economic data, most focus this coming week will be on the ECB rate decision and monetary policy statement on Wednesday, and US CPI and the Michigan consumer sentiment index for May to be released on Friday.
THE TABLES
Global equities
US and European markets started off the new month with losses, whilst the Asian and emerging market equities notched nice gains. The US had a four-day week (Monday Memorial Day holiday), and the UK had a three-day week (Queen’s Jubilee holidays on Thursday and Friday). Equities in China have posted nice gains over the past four weeks as investors seem to believe the worst of the COVID-related shutdowns have now passed.
US equities
US equities were volatile day-to-day this week, although the turning point seemed to be the strong jobs report on Friday, which pushed UST yields higher and US indices to their worst day of the week, crystallising losses for the week and for the start of June. The S&P 500 took the worst beating on Friday and was the worst performing index of the week. The VIX is struggling to get back below 25, as volatility remains elevated, and investors remain nervous for a variety of reasons. US equities remain poor across the board this year, with the DJIA (large caps, concentrated index) serving up the least bad return (-9.5%), and – not surprisingly perhaps – the NASDAQ Composite serving up the absolute worst return YtD (-23.2%).
US Treasuries
US Treasury yields started to move wider on Wednesday, and Friday’s strong jobs report was fuel on the fire as yields widened even further. The short period of time in May when USTs rallied as a safe haven asset play whilst equities were spiralling downhill seem to have ended, as equity prices have stabilised (can I say that?) and risk appetite has returned, at least until mid-week. Meanwhile, inflation concerns have come back into focus with UST yields moving wider and the yield curve steepening. For example, the yield on the 10y UST peaked at 3.12% on May 6th, decreased 38bps over the next three weeks to 2.74% (May 27th) before widening out 22bps this holiday-shortened week to end at 2.96%.
Corporate bonds (credit)
Safe haven and other assets
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