May was an unusual month. Italian politics dominated interest rate markets. Although the month got off to a relatively quiet start, it didn’t stay that way for long. At the start of the month, President Macri of Argentina could only see one way out in the wake of soaring interest rates and the collapse of the peso and that was to ask the IMF for assistance. The Turkish lira continued to weaken, forcing a sharp increase in interest rates there. At the end of the month, it was announced that US import tariffs would after all be imposed on steel and aluminium for the Eurozone, Canada and Mexico as of 1 June. China can also expect additional measures. All these events are significant, but in May they were completely overshadowed by the formation of a government in Italy.

Italy’s general election in March of this year was won by two populist parties: the Five Star Movement led by Luigi di Maio and the Lega led by Matteo Salvini. Although there are huge differences in their manifestos, they did ultimately initiate negotiations. This was the only remaining option for forming a government. Together they hold a small majority in parliament, as well as sharing criticism of Eurozone policies. Markets responded nervously to comments about the euro. Bond spreads widened in Italy and other peripheral EU countries followed this widening. The two parties finally agreed a governing manifesto that includes tax reforms to create two tax brackets of 15% and 20%, the scrapping of pension reforms, a minimum wage and a fierce anti-immigration policy but nothing on an exit from the Eurozone. These policies will create a higher budgetary deficit, but the parties seem more than willing to stand up to the EU on this. This increased uncertainty on the financial markets, which was later exacerbated when the parties absolutely insisted on Savona, an ‘anti-euro’ professor, as Minister of Finance. President Matarella felt the pressure from the markets and rejected the plan. Markets initially responded with relief, but this was of short duration. Market confidence deteriorated and volatility hit an interim high on Tuesday 29 May. On the bond market, trade in peripheral EU bonds and many credits ground to a complete halt. In Italy, the parties returned to the negotiating table and finally reached agreement. The new government will be headed by Guiseppe Conte, a law professor with no political experience, with Professor Giovanni Tria holding the portfolio for Economics and Finance. President Matarella approved the list of government ministers. This has restored some calm to the markets, but all the indications are that the turbulence is far from over.

In Spain, Prime Minister Rajoy was deposed by parliament following accusations of corruption within his party. He has been replaced by PSOE leader Pedro Sanchez. No structural changes in policy are anticipated thanks to the heterogeneous government and the small majority it holds in parliament. The euro is not up for discussion in these parties. Eurozone economic indicators published in the meantime were fairly positive. Manufacturing confidence and purchasing managers indices were up slightly again and consumer confidence remains strong.

Oil prices fell 2% in May, partly aided by the stronger US dollar; oil prices even rose slightly in euros. Inflation figures again pointed to a further increase in inflation in May. In Germany, year-on-year inflation stood as high as 2.2%. Purely based on economic indicators, as early as June the ECB could provide more information on how it intends to scale back its expansionary monetary policies. A reduction in 2018 from the current level of EUR30 billion per month until September 2018 to zero from January 2019 is still possible. However, the ECB is likely to postpone any decision until July in order to take the time to analyse the impact of the situation in Italy.

German 10-year bond yields decreased by 22 basis points (bps) in May. This was due to a flight to safety within the Eurozone. The swap rate decreased by 9 bps for this maturity. The entire yield curve followed suit, with the exception of 2-year yields which only declined by 7 bps in Germany and remained unchanged in swaps. Our underweight in the portfolio’s sensitivity to rates against the index contributed negatively to the relative performance. Inflation-linked bonds again performed slightly better thanks to the weaker euro and higher inflation figures.

The largest movement was in peripheral EU government bonds. German government bonds earned a return of 1.7% in May. Other core countries also yielded positive returns, but they were lower than those in Germany. Italian government bonds performed extremely poorly and lost 6.6% during the month. Spanish government bonds stood at -1.8%. The general euro index lost 1.3% on balance. Our positioning held a slight overweight in peripheral EU countries. We expected the sound economic data and continuation of the ECB’s bond-buying programme to support the differences in yields. However, even a slight overweight had a major impact and resulted in a sharply negative contribution to the relative return. During the month, we reduced the position in Italy and increased the underweight in France in order to protect the portfolio against extreme escalation, but the underweight in France yielded little compensation. The dramatic response to the political turmoil in Italy also demonstrates that the market consensus was excessively optimistic. Italy may now have a government, but the situation is far from stable. The differences in yield compared to Germany could remain relatively large; time is what is needed. The other peripheral EU countries in particular could well recover. For Italy we anticipate a smaller spread on short-term government bonds, while longer-term government bonds will require more time.

Government-related paper experienced a relatively poor month. In practice, these bonds are trading more or less in line with swap rates. As mentioned above, swap rates lagged well behind German yields and investors sought shelter in the safe haven of German government bonds in May. We expect the negative contribution from government-related paper to reverse relatively rapidly and also see opportunities in this sector.

The portfolio is positioned for higher bond yields and smaller differences in yields against Germany. The Italian political arena should now calm down somewhat and permit smaller spreads on government-related paper and peripheral EU government bonds. The sound economic data and gradual withdrawal of central banks continue to provide a boost for higher yields and the response to the political turmoil has been very extreme. For the time being, we will continue to closely monitor the political situation in the Eurozone and the impact of the reduction in the ECB’s bond-buying programme.