Fed sees further gradual rate hikes as the best way forward; there has been more upward pressure on Italian yields overnight; USD and US Treasury yields have risen marginally; NZD has drifted lower

By Nick Smyth

There has been more upward pressure on Italian yields overnight, although with limited spill-over to other markets.  The Dow Jones hit a new record high.  Fed Chair Powell gave a speech a short while ago but didn’t add much new information, and reiterated that the Fed saw further gradual rate hikes as the best way forward. 

Risk sentiment generally remains strong, despite further volatility in Italian government bonds.  The recently agreed NAFTA deal has provided a positive backdrop for risk assets, with the Dow Jones making a new record high overnight.  The S&P500 was up slightly, and within 0.5% of its record level set late last month.  The Russell 2000, a small-cap US equities index, bucked the trend and fell 0.6%.  Small-cap stocks are generally more domestically focused, and therefore do not benefit to the same extent from an easing in trade tensions as the major US equity benchmarks, which predominantly comprise large multi-nationals. 

Focus on Italy remains heightened, with Italian yields moving higher once again and weighing on the euro.  The Italian 10 year yield moved 15bps higher, with the spread to German bunds widening to 300bps at one point, after prominent Italian Eurosceptic MP Borghi said the euro was “not sufficient” to solve Italy’s fiscal problems.  Borghi quickly clarified that his personal view did not extend to the government (“there is not plan to leave the euro within this government regardless of my personal conviction”) and Prime Minister Conte later added “[the] Euro is our currency, irreversible”.  Either way, polls released after the bout of volatility earlier this year showed that Italians favoured euro membership by a decent margin, if the government were ever to go down the unlikely route of a referendum. 

The market’s medium-term concern is that Italy may ultimately be downgraded to ‘junk’, leading to a wave of forced selling by investors who have minimum credit rating restrictions.  Moody’s and S&P review Italy’s sovereign rating before the end of October (after the budget has been submitted to the European Commission).  All three major rating agencies rate Italy “BBB” (i.e. two notches above junk), and even if Moody’s were to downgrade Italy at the end of next month (its outlook is negative), it would likely be quite some time (and probably some reckless fiscal decisions) before a downgrade to junk becomes a possibility.  In the more immediate future, there’s likely to be more negative headlines and volatility around the submission of the budget to the EC in mid-October, but we don’t expect Italian yields to skyrocket like they did earlier this year when the market started to question Italy’s membership of the euro.  Consequently, there should be continue to be relatively limited spill-over to major risk asset markets. 

Italian concerns have continued to weigh on the euro which fell to as low as 1.1505 during the London morning.  But it has found support around that level and has since bounced towards 1.1550.  The NZD and AUD have largely mirrored the moves in the EUR.  The USD is slightly higher on the day, by around 0.2% on the various indices we track, but currency moves have been reasonably contained. 

The USD and US Treasury yields have risen marginally since Fed Chair Powell delivered a speech a short while ago, although we didn’t glean any new information from it.   Powell reiterated that continued gradual Fed rate hikes were the best way balance the risks of tightening too fast (and cutting short the expansion) and tightening too slowly (leading to overheating and higher inflation).  Powell stressed the importance of stable inflation expectations and he again alluded to the late 1990s as a period when the unemployment rate was very low and wages increased faster than productivity, but there wasn’t an appreciable rise in inflation.  The 10 year US Treasury yield is 3.06%, down 2bps on the day, mainly due to the 5bp decline in German bund yields (itself mainly related to concerns around Italy).   There was no major economic data released overnight. 

Against a backdrop of a slightly stronger USD, the NZD has drifted lower over the past 24 hours – it currently sits just under 0.66.  There was a modest negative reaction to the QSBO yesterday, with the NZD falling around 25pips after its release.  We didn’t think the survey was as weak as the headline confidence number suggested, with future employment intentions rising and the forward looking own-activity indicator pointing to growth of around 2.5%.  Respondents pointed to rising cost pressures and frustration with government policy as their main gripes, rather than a lack of demand.  There was little reaction in the rates market to the QSBO, with the 2 year swap rate closing 1bp lower on the day and little movement further out the curve.  Overnight, there was a further modest decline in dairy prices at the Global Dairy Trade auction. 

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