1. ECB Meeting – Some Further Thoughts Having had an extra couple of days to digest the European Central Bank’s (ECB) announcement and subsequent press conference, we think that ECB President Draghi will have enjoyed a glass of Chianti this weekend, quietly happy with the job he did last week…..
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Tanguy Le Saout, Head of European Fixed Income, Pioneer Investments
For a start, he avoided committing the ECB to any action, even though most investors are expecting that an extension of QE will eventually be forthcoming. That in itself has introduced a more two-way tone to markets in the past few days. Secondly, he has engineered a steepening of the yield curve, which helps the beleaguered Banking sector and offers them some respite from the effects of negative rates. Thirdly, he has given markets an idea of what life may be like when the ECB finally do stop buying bonds, or when they start their own tapering programme. Fourthly, the market probably now needs to start debating when that tapering may occur, rather than blindly believing that QE will forever be extended and/or increased. Fifthly, Draghi again pointed to the fact that central banks on their own cannot boost world economic growth, and that help is needed on the fiscal side. This argument is increasingly gaining traction and appears to be gaining credence amongst government officials. Lastly, and in quite a clever move, the back up in yields has already eased the fears of investors about bond scarcity. Remember, the ECB currently cannot buy bonds whose yield is lower than the deposit rate of -0.40%. The rise in yields in the last few days has just increased the amount of bonds the ECB can buy. Every cloud has a silver lining.
2. European Politics – Interesting Times Ahead
A recent poll by Barclays Bank showed that global investors believe that the biggest risk to markets over the next 12 months will be geo-political developments. With the UK’s Brexit vote having surprised markets, politics looks to have the capacity to significantly influence asset prices in the coming months.
In Spain, incumbent Prime Minister Rajoy is still struggling to form a government, nine months after a national election last December. Rajoy’s failure to secure a parliamentary majority after two votes at the end of August makes a third election in Spain in 15 months a possibility. Spanish government bonds have performed strongly in recent months, mainly driven by a decent recovery in economic growth, but this renewed political uncertainty could take its toll.
Across in Italy, the long-awaited referendum on parliamentary reform is now due to be held in late November or early December. Prime Minister Renzi has been backing away from his claim that he would resign if the referendum wasn’t passed, but a loss would still be a significant blow to his reputation. However, the 5SM party, who made large gains in local elections a few months ago, have suffered a difficult time since their victories, especially in Rome where political scandals have dented their reputation.
In France, the race for the Presidency has started in earnest, despite the election not being until late April / early May 2017. Current President Hollande is trailing a long way behind in the opinion polls, and his prospect of re-election is looking increasingly remote.
Finally, in Germany, although the elections aren’t due until 2017, Chancellor Merkel’s Christian Democrat party suffered one of their worst results in the party’s history at last week’s election in Frau Merkel’s home state. Ending up with 20% of the vote, the Christian Democrats came in third after the AfD party, a nationalist anti-immigration party.
Whilst all this is happening, U.K. Prime Minister Theresa May is trying to set a date to trigger Article 50, thus starting the formal process of the UK’s exit from the EU. Could it be that Mrs May will end up negotiating with new leaders of the four largest countries in Europe? Either way, investors are probably right to worry that geopolitical uncertainty will be a big influence on markets.
3. Bond Yields – A Tired Bull or Just Having a Rest?
In last week’s blog, we mentioned that volatility appeared to be quite low across different asset classes, and right on cue volatility spiked higher at the end of the week. Mainly blamed on market disappointment with the ECB announcement (or lack of announcement), bond markets in particular experienced their first major sell-off for some time. German 10-year Bund yields rose back into positive territory – the last time they were positive was in mid-July 2016. 10-year US Treasuries broke their recent tight trading range, whilst one of the more interesting moves occurred in Japan, where the yield curve steepened significantly as the 30-year bond underperformed other maturities. Investors are fretting that this could be the start of another big move in yields, a la the infamous Taper Tantrum of 2013 or the near-100bps rise in yields seen in Q2 2015. We have been expecting a rise in bond yields for some time now, and we think there could be more to go in terms of yield rises. The positives for bond yields are that, as mentioned above, we expect the ECB will announce an extension to their QE programme in December, so that should help to sooth investors nerves. We also believe that we have yet to see the full impact of Brexit on economic activity, which in Europe is already showing signs of slowing from levels experienced in Q1 2016. Neither is inflation going to be a problem, with even the ECB admitting that they will struggle to meet their inflation target by 2018. Finally, the demand/supply outlook for the balance of 2016 is very positive, with many debt management agencies already having done most of their 2016 funding.
So we should see less supply and continued buying from the ECB. On the negative side, there have been large bull-flattening curve positions (investors expecting the long-end to outperform) built up over the past few months, and these will probably now be reversed. Secondly, the technical situation looks difficult in general, with many markets breaking key resistance levels. Thirdly, the scale of the moves in the past couple of days (combined now with weaker equity markets) could cause a VaR shock for some investors, leading to position liquidation. For the moment, as mentioned above, we continue to believe a short duration stance is warranted.