Strong Employment Report Overshadowed by European Central Bank
The U.S. Bureau of Labor Statistics reported another month of strong jobs growth on Friday as June payrolls increased by 222,000 and prior months were revised higher. Wage gains remain moderate, but the unemployment rate remains at historically low levels, showing signs of a tight labor market for those who are willing and able to work. The jobs data provide further evidence of a relatively strong U.S. economy, but the report was overshadowed by a surprise from across the Atlantic. The release of the most recent European Central Bank (ECB) meeting minutes on Thursday caused mild turbulence in global bond and stock markets, as rates in Europe and the US moved higher and stocks declined. Investors should pause and consider the ramifications of a potential change in ECB policy.
The ECB minutes reinforce recent statements made by ECB President, Mario Draghi. Draghi intimated that recent economic data suggest deflationary pressures have subsided within the Eurozone. The market interpreted the statement as a hawkish signal and caused global rates to move higher in anticipation of the possible end of easy money in Europe. If the economic data in the EU continues its current trend, it is likely the ECB will reduce quantitative easing measures sooner than previously expected. Considering the more hawkish sentiment from the ECB in conjunction with the continued pattern of strong economic data emerging within the US, the mild spat of volatility experienced Thursday may be magnified if the era of negative interest rates in Europe is truly nearing its end.
The ECB’s negative interest rate policy of the past two years has caused European investors to travel beyond the confines of their home markets. Since the end of 2015, short-term rates have been in negative territory for the vast majority of European economies. This led many European investors to look abroad, particularly to US government bonds, corporate bonds, and equities, for attractive investment opportunities. The increased demand for US assets has been manifested in a strong dollar, low interest rates, tight corporate credit spreads and healthy stock valuations. These conditions are certainly not solely attributable to the policy actions of the ECB, as corporate profits have increased and US economic growth has easily outpaced Europe and other developed markets, but the easy money policy in Europe has certainly contributed to hot capital entering the US in search of reasonable investments relative to other markets. Therefore, today it is perhaps more important than ever to pay attention to ECB policy.
A shift in the extremely accommodative monetary policy currently in place at the ECB is likely to impact markets in the US. Capital from European investors may leave our markets and return home as European rates become marginally more attractive. Direct implications of ECB policy are evident within long-term global rates: the US ten-year marched higher following comments from the ECB, in concert with long-term European rates. In spite of the small bout of volatility experienced in markets on Thursday, the MOVE Index, a gauge of US government bond volatility, recently hit an all-time low. However, it is worth noting that the ten-year Treasury rate has moved in excess of 100 bps from peak to trough in most calendar years over the past decade, so the recent market complacency doesn’t look sustainable. Bond yields have varied from a high of 2.62% to a recent low of 2.12% this year, a range of only 50 basis points. If both the ECB and the Fed take the path toward more hawkish monetary policy, rates in the developed world could move markedly higher.
Beyond a potential move in interest rates, the indirect implications of a shift in ECB policy are worth considering, too. A sharp decline in demand for US assets could take investors by surprise and cause volatility to return to currently sanguine US financial markets. This has the potential to increase corporate bond spreads and cause a spike in stock market volatility. Recent statements do not suggest that the ECB will catch up to the Fed in tightening policy anytime soon, but both institutions may be headed in the same direction sooner than expected and investors should remain on alert.
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