As the second quarter drew to a close, central bankers were doing a lot of talking, and causing some anxiety in the process. In particular, comments by European Central Bank (ECB) President Draghi, citing economic progress in the Eurozone, were construed as preparing markets for the eventual winding down of its bond buying program, as a first step toward its policy normalization. The current program is scheduled to run through the end of the year. Currency markets reacted immediately, pushing the euro to a nine-month high versus the dollar. However, it didn’t take long for the bank to make it clear that those comments had been misinterpreted, that no such hawkish shift was intended.

Nevertheless, the euro held onto most of its strength, ending the week at 1.143, up from 1.119 the week before. Bond markets reacted just as swiftly. The yield on the ten-year German bund spiked from 0.24 to 0.46 percent, while in the U.S. the ten-year note yield jumped from 2.14 to 2.30 percent. Despite the ECB’s protestations, it is clear that the level of anxiety regarding the ECB’s intentions had increased, and the implications for bond and currency markets was being reassessed.

The Fed Appears to be Staying the Course

In the U.S., Fed Vice Chairman Stanley Fischer, speaking to an International Monetary Fund (IMF) workshop on financial stability, commented on the rise in asset valuations saying, “The increase in prices of risky assets in most asset markets over the past six months, points to a notable uptick in risk appetites, although this shift has not yet led to a pickup in the pace of borrowing or a sizeable rise in leverage at financial institutions.” Fischer went on to comment that despite the rise, in the risk-free rate equity valuations were in the top quintiles of historical experience, corporate bond spreads were near post-crisis lows, and commercial real estate capitalization rates had reached historic lows.

So, despite another soft inflation reading from the May Personal Consumption Expenditures (PCE) deflator, the Fed seems intent on staying the course regarding its own normalization process, focused not only on its belief that inflation, driven by wage gains, will eventually approach its 2 percent target, but also mindful that asset prices have become stretched.

Financial Stocks on the Rise

While bond and currency markets experienced a rise in volatility, financial stocks welcomed the rise in yields and the modest steepening of the yield curve. Financial stocks in the S&P 500 rose 3.3 percent last week, as the spread between the two and ten-year yield rose from 80 to 91 basis points. Also helping was a clean bill of health for the nation’s largest banks from the latest round of stress tests, and a green light for their capital deployment plans. After several months in the doldrums, financial stocks in the S&P 500 have now climbed 7.7 percent since the middle of April, led by an 8.6 percent rise in the banks.

The next Fed meeting is scheduled for July 25-26. Not being a meeting also accompanied by a press conference, no meaningful change in policy is expected. That will likely have to wait until September, when speculation will center around if and when the next rate hike will come, as well as when the Fed may begin the process of winding down its balance sheet, and the appropriate sequencing of the two. The ECB meets next on July 20. With important decision points quickly approaching for both institutions, bond and currency markets can be expected to remain jittery.

Important Disclosures:       
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
Indexes are unmanaged and are not available for direct investment.
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
Ameriprise Financial Services, Inc. Member FINRA and SIPC.