Head of Global Macro and Portfolio Manager
• Quarterly outlook
Fixed income outlook: Fiscal hurricane season
The events in Europe following the European elections underscore how political developments can suddenly take center stage.
Authors
Summary
- Political risks gain prominence after surprise French snap election
- Rate cuts pushed out as Fed and ECB await slower services inflation
- Remain constructive on intermediate tenors and high-rated SSA and covered bonds
Euro government bond spreads ground tighter with relatively low volatility over the past 12 months, benefiting from the constructive risk mood in markets. However, sentiment changed overnight after French President Emmanuel Macron’s party suffered a major defeat in the European elections. Mr. Macron’s surprise announcement of parliamentary elections was seen by markets as adding fuel to the fire. A victory for parties with a fiscally expansive agenda increases the risk of deteriorating French public finances, which are already under market scrutiny.
Bond market volatility surged once again as Euro country spreads widened sharply, fueling a flight-to-quality into Bunds. The 10-year OAT-Bund spread widened by approximately 30 bps to just under 80 bps — levels not seen since the run-up to the 2017 French presidential elections and during the 2011 euro crisis. This widening affected spreads across all euro countries and spilled over into the broader euro credit complex. Additionally, European bank stocks experienced significant pain, with a sharp (8%) decline in the Euro Stoxx Bank Index over five days. These developments highlighted that valuations in spread markets had become stretched, as noted in our Q2 outlook.
Prepare for changeable conditions
This demonstrated that while markets were focused on inflation and central bank meeting outcomes, geopolitical developments can have sudden and significant impacts on on markets. With elections coming up in the United Kingdom and later this year in the United States, where fiscal uncertainties are also elevated (see Figure 1), we could be in for a tempestuous summer and perhaps an equally stormy autumn.
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