Bond Market Observations: Navigating Sharp Corners

As investors, we detest sharp-cornered outcomes associated with political decisions. Binary choices include yes or no to a referendum, Republican or Democrat as US president, or principal payment versus default on a bond. While the event happens after the fact with the probability of zero or one, before the fact markets assign a probability between zero and one (unless the result was painted on the wall by surprise-averse officials such as those populating the Federal Reserve). When politics are in play, it is hard to have a forecasting edge, a point call may turn out to be completely wrong, and financial prices are sure to adjust on the resolution of the event as the probabilities embedded in valuations move to zero or one.

A particular irony is from the other perspective—sitting as a policymaker in front of a discrete event—the discipline of a sharp corner sometimes elicits calming behavior in the official community, mostly in a manner similar to adventurers sneaking around the sleeping jungle cat in the movies. In the current environment, we think that there are four sharp edges in the future that increase our confidence about the near-term outlook, even though this may be understood, in retrospect, as living in the calm before the storm. And besides, we believe that, now the Fed has a cushion for its policy rate above the zero lower bound, central bank officials would step into the fray to diffuse market strains if political outcomes are somewhat more ragged than expected.

The corners in our future include:

  1. The threat of catastrophe in the US midterm elections will make Republicans in the Congress cooperate with a president that some view, to put it delicately, with mixed feelings. The drama played out between Capitol Hill and the White House over the past few days over the American Health Care Act, notwithstanding, we think that the Administration gets to yes on a few issues because nothing but no is untenable.
  2. The French and German elections lurk in the nightmares of European Central Bank president Mario Draghi. His strategy will be to keep the stance of policy unchanged so as not to attract attention. Because that stance is very accommodative, ECB easing continues almost full-throttled as the European economy revives.
  3. President Xi of China intends to consolidate power at the November Communist Party conference. Delivering steady economic growth and brooking no foreign slight are top priorities before then. Officials have enough levers of power to get what they want, at least for now.
  4. The attempt by a new generation of leaders in Saudi Arabia to reduce the oil dependence of that economy faces a significant market hurdle—the planned public sale of a portion of the state oil company. Read the enforcement and potential extension of quota cutbacks as an official attempt to provide a stable market backdrop to yield the best possible price for that initial public offering.

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