As the Brexit effect continues to ripple through markets this week, sovereign bond yields have rallied to fresh lows and the US Treasury curve continues to flatten. Historically such aggressive falls in yields and the extent to which the US curve has flattened have indicated an approaching recession; we think it is a bit too early to call for a recession at this stage as moves have been amplified by global financial market uncertainty. However, we do not see any upside pressures in the short-term as concerns over global stagnation and further weak to mixed economic data will no doubt dampen already fragile market sentiment. In fact, the relatively cautious minutes from the June FOMC meeting released yesterday indicate a further delay in rate hikes and an even more gradual pace to future rate rises, with repeated reference to the “uncertainty”.
Fed governor, Daniel Tarullo yesterday stated that even before any Brexit risks are considered, US employment and inflation readings do not meet conditions for a rate hike. He commented that the Fed should wait for more evidence of inflation picking up to the central bank's 2% level saying “Inflation is not at our stated target, nor near our stated target, and hasn’t been so in quite some time”. The Fed’s favoured inflation measure, the core PCE Index, rose to 1.6% yoy in May. Tarullo went on to comment on the slack within the labour market adding, “This is not an economy that is running hot”.
We have long said that we believe the Fed would struggle to raise rates this year and now with the added Brexit spanner in the works it appears that 2017 is out of the picture too; well according to the futures market anyway. We look to the non-farm payroll release tomorrow to give any further indications of where the Fed’s thoughts lie. After last month’s surprisingly weak reading, the market will be looking for an expected +180k jobs added in June at a bare minimum.
Meanwhile, seemingly unperturbed by recent market events are our holdings in the Middle East and Russia; also the best performing regions in the first half of the year. Qatar sovereign paper continues to head higher, the 6.4% issue maturing in 2040 for example has rallied roughly 6 points since the referendum results were announced, tightening ~33bps to a yield of 4%. Russia came to the market with a 10-year RUB 20bn (USD 309m) auction yesterday, the issue, with an average weighted yield of 8.57% was well absorbed by the market which is desperate for yield. We hold only hard currency bonds within our portfolios, the likes of Russian Railways (GBP) 7.487% 2031 and USD Gazprom 8.625% 2034 have continued to outperform, gaining on average 18 points since the start of the year and continue to offer attractive yields of 6.2% and 5.9% respectively.