Fed Rate Hike Expectations Tumble on Italy Concerns

Three months after Italy’s election, political uncertainty has led to heightened concern that Italy’s populist coalition may try to pull Italy out of the European Union (a trade union) and the Eurozone (the euro currency union). The possibility that Italy could leave prompted investors to reassess the risk of Italy’s government debt and aggressively sell Italian government bonds. LPL Research Chief Market Strategist John Lynch adds, “We do not see Italy leaving the E.U., but we expect continued uncertainty in Europe as anti-establishment parties and referendums proliferate.” Short- and long-term yields experienced historic spikes, with the Italian 2-year bond’s yield moving from 0.5% to 2.7% over the last two trading days (May 28-29, 2018). On May 8, 2018, just three weeks ago, that same bond was yielding -0.3%. The flight from Italian bonds led to a risk off day in which stocks fell globally, and investors flocked to safe haven assets like U.S. Treasuries.

Importantly, the selloff in government debt did not hit Europe broadly. Yields in Germany, for instance, fell impressively as European investors sought refuge in the perceived safety of German government bonds. Yields fell similarly in the U.S. as the flagship 10-year Treasury yield tumbled 15 basis points (0.15%), its largest daily decline in almost two years. U.S. short-term yields also fell sharply, with the 2-year Treasury yield dropping 16 basis points (0.16%).

These moves were accompanied by a dramatic shift in Federal Reserve (Fed) rate hike expectations. Just one week ago, the market-implied number of total Fed rate hikes in 2018 was approximately 3.5, representing an even split as to whether the Fed would hike rates three or four times this year (we already got one). That number fell considerably yesterday, with the market now pricing in just over 2.5 hikes in total. In essence, investors perceived the mounting risks in Europe to warrant almost one less rate hike this year than just one week ago, a meaningful shift in investor sentiment.

As is usually the case, markets may have overreacted in the short-term, but only time will tell. We think the global economic backdrop, particularly in the U.S., remains intact. While we believe this is certainly an ongoing risk worth monitoring, we don’t believe it to be the bellwether of a large change in the global economic trajectory.

 

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