A risk off tone dominated global markets into the end of last week as concern about the political crisis in France deepened. US consumer confidence weaker than expected. Global bond yields moved lower

A risk off tone dominated global markets into the end of last week as concern about the political crisis in France deepened. European equities were under pressure with the Euro Stoxx falling 2% and the spread between French and German 10-year bonds increased to 77bps, the widest level in more than 10 years. The impact on US equities was more muted with the S&P recovering from an early session dip to close unchanged. Global bond yields declined, and the dollar was broadly stronger.

European markets have been roiled amid a pickup in political risk premium since French President Macro called a snap election. Polling showing the rise in populist parties is increasing investor concerns about the fiscal outlook. French credit default swaps are now trading in line with lower rated Spain and Portugal. The CAC 40 index fell more than 6% over the past week and the euro has been the weakest G10 currency in the same period.

University of Michigan’s consumer confidence index was weaker than expected. The index fell to 65.6, well below the consensus estimate of 72.0, and is set against the backdrop of lower gas prices and higher stock markets which would generally support confidence. The expectations index, which has a better relationship with consumer spending, registered a smaller decline.

Medium-term inflation expectations increased to 3.1% from 3.0% and have been slow to retrace despite the decline in actual inflation. However, due to recent changes in the collection of the data, University of Michigan said the poll of longer-run inflation expectations should be ‘interpreted as essentially unchanged’.

Fed policy makers have emerged from the pre-FOMC blackout period. Cleveland Fed President Loretta Mester said that while the inflation data has been welcome news, she still sees inflation risks as skewed to the upside, and a few more months of good figures are needed before interest rate cuts happen. The market is pricing about 50bps of Fed rate cuts by the end of the year following the FOMC and inflation releases last week.

The Bank of Japan kept its policy rate unchanged at 0.1% as was widely expected and plans to reduce its JGB purchases. However, the plan for reduced bond buying will be specified at its next meeting, and the timing came as a disappointment to the market, contributing to a knee-jerk move lower in the yen. After falling as much as 0.8% against the dollar, to the weakest level since the market intervention in late April, the yen recovered.

Investor risk aversion contributed to lower global bond yields with the largest moves in German bunds where 10-year yields fell 11bps to 2.36%. 10-year US treasury yields extended the recent rally falling 3bps to 4.21%, the lowest level since late March. The yield curve bull flattened with 2-year yields little changed at 4.70%. The 2y/10y treasury curve is back at the flattest level for the year near -47bps.

The US dollar was generally stronger with the largest gains against European currencies. EUR/USD traded below 1.07 to 1-month lows before staging a modest recovery. The yen rebounded from the post-BOJ weakness and outperformed along with the Swiss Franc given their defensive properties amid a softer risk backdrop. NZD/USD dipped to lows below 0.6120 aligned with the broader dollar backdrop. NZD/AUD was stable while the NZD ended higher against the euro and pound.

NZ fixed interest markets ended the local session on Friday lower in yield. Offshore markets set the initial tone which gained support from the weak manufacturing PMI and soft inflation partials. 2-year swaps closed 6bps lower at 4.93% with the curve a touch flatter. 2y/10y is back towards the recent lows at -50bps. 10-year government bonds closed 6bps lower at 4.61%.

Selected price indicators for May were generally soft and suggests some downside risk to our 3.6% forecast for Q2 headline inflation which is released mid-July. Our forecast matches the RBNZ’s 3.6% projection from the May Monetary Policy Statement. The manufacturing PMI declined to 47.2 in May, extending the length of time in contractionary territory to 15 consecutive months.

Australian 10-year government bond futures are 6bps lower in yield terms from the local close on Friday, pointing towards lower NZ yields on the open.

The services PMI is for May released today. The index reached the weakest level in more than two years in April. Monthly China activity data will be monitored with investors looking signs of recovery in very weak consumption. The Peoples Bank of China is expected to leave its MLF policy rate unchanged at 2.5%.

[chart;daily exchange rates]