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Moody's Weekly Market Outlook Summary

Core Content

Moody's Weekly Market Outlook provides insights into credit markets, economic forecasts, and market data for the US, UK/Europe, and Asia-Pacific regions. The report is authored by Moody's Capital Markets Research and includes contributions from several analysts, including John Lonski, Njundu Sanneh, Franklin Kim, Yuki Choi, Tomas Holinka, and Katrina Ell. The report also highlights the performance of financial indicators and forecasts for key economic metrics such as GDP, inflation, and bond yields.

Main Views

1. Treasury Bond Yields and Fed Policy

• The Fed's passive reduction of its bond holdings may not result in a significant rise in Treasury yields, as seen in the aftermath of QE3.
• Historical data from October 2014 shows that Treasury yields actually remained lower than consensus expectations, indicating that forecasters overestimated the impact of QE3's end.
• The report suggests that if yields rise too quickly without a corresponding acceleration in economic activity, it could lead to a market correction, equity price declines, and increased recession risk.

2. Corporate Bond Yield Spreads

• Corporate bond yield spreads, particularly for Baa-rated and high-yield bonds, have widened during and after the exit of QE2 and QE3.
• The correlation between the average high-yield EDF (Expected Default Frequency) and bond spreads is strong, with the EDF rising from 2.5% during QE to 4.2% otherwise.
• The median high-yield EDF also increased, showing that even with some industry-specific volatility, the overall default risk in the market is on the rise.

3. Systemic Liquidity and QE Impact

• The presence of systemic liquidity, fueled by QE, has kept default risk and yield spreads lower.
• As the Fed withdraws stimulus, liquidity may decrease, potentially increasing yield spreads and default risk.
• The VIX index has shown a slight increase, indicating higher market volatility, which is consistent with reduced liquidity.

4. Fundamentals Determine Bond Prices

• The Treasury market is currently in a "price search" phase, trying to determine the likely range for yields as the Fed reduces its bond holdings.
• The report emphasizes that fundamentals, such as GDP growth and inflation, ultimately dictate bond prices, not just market sentiment or expectations.

Key Economic Forecasts

United States

• Inflation (CPI): Expected to remain unchanged in June, with core CPI likely rising by 0.2%. Headline CPI is expected to decelerate to 1.7% year-over-year.
• Retail Sales: Projected to rise by 0.1% in June, with core retail sales (excluding autos, gasoline, building materials, and restaurants) expected to increase by 0.3%.
• Industrial Production: Forecast to rise by 0.2% in June, with manufacturing output showing mixed signals due to retooling and seasonal factors.
• Jobless Claims: Expected to fall to 243,000 in the week ending July 8, but the four-week moving average will still rise.
• Consumer Sentiment (University of Michigan): Preliminary forecast for July is 94.7, down from 95.1 in June, but lower gasoline prices may limit the decline.

Europe

• Euro Zone Industrial Production: Expected to show strong growth in May, with Germany, France, and Spain exceeding consensus estimates.
• France Inflation: Projected to moderate to 0.7% year-over-year, with subdued household income and slow wage growth limiting price pressures.
• Spain Inflation: Expected to rise to 1.5% year-over-year, supported by a drop in unemployment, but consumption data suggest continued inflationary weakness.
• Italy Trade Data: Expected to show a modest increase in industrial production, but manufacturing PMI weakened, signaling concerns about the broader economy.

Asia-Pacific

• China GDP: Likely grew at 6.9% in Q2 2017, driven by a recovering global economy and a strong housing market.
• China Trade: Expected to show a trade surplus of $43 billion in June, up from $40.8 billion in May, due to improved global demand.
• South Korea Policy Rate: Remains at 1.25%, with rate normalization expected to begin in early 2018 due to elevated household debt.
• Singapore GDP: Forecast to grow at 3.2% year-over-year in Q2 2017, improving from 2.7% in Q1.
• India Wholesale Price Index: Likely to decelerate to 1.8% in June, down from 2.2% in May, due to falling food prices and increased stockpiles.
• India Trade Deficit: Expected to widen to -$13.9 billion in June, driven by rising energy costs and strong import activity.
• Indonesia Trade Surplus: Likely to expand to $780 million in June, after narrowing in May due to increased consumer imports.

Conclusion

The report underscores the importance of economic fundamentals in shaping credit market dynamics and bond yields. It highlights that while the Fed's tapering of bond purchases may lead to higher yields, the market's reaction will depend on the underlying strength of economic activity. The analysis also notes that corporate bond spreads have historically widened during the exit of quantitative easing, and that the median EDF is a more accurate measure of default risk than the average. As the Fed reduces its stimulus, the market may need to adjust to a new reality, where liquidity is less abundant and economic fundamentals play a more dominant role.