Fixed income after the ECB rate cut
The immediate reaction in bond markets to ECB’s latest announcement on monetary policy might suggest disappointment. Core bond yields rose rapidly because the ECB failed to announce any increase in the size of quantitative easing (QE) purchases.
The euro rallied against the dollar because the expectations generated by ECB President Draghi were not fulfilled – he did not pull all the policy levers that he had talked about recently. Risk assets – credit spreads and equities – reacted negatively.
Yet, in the end, he delivered a further loosening of monetary conditions by cutting the deposit rate by an additional 10 basis points (bps) to a level of -30bps, and by extending the QE programme beyond September 2016.
Rates are lower and the ECB balance sheet will grow by more than was the case at midday today.
For global investors, the central theme of a divergence in monetary policy remains intact. The Federal Reserve (Fed) is expected to raise rates on December 16th.
Financial conditions point to a renewed period of US dollar strength. The differential between US and European bond yields will move higher.
The ECB is still trying to generate a higher level of inflation while the Fed is hoping that the recent increase in inflation momentum in the US can continue and will not be curtailed by at the very most, an increase in rates.
From an investment strategy point of view, exposure to inflation linked bonds relative to nominal bonds looks attractive.
Don’t fight the central banks even if they can be a little disappointing. European bond yields are likely to be dragged lower by the reduction in the interest rate floor while US bond yields will move in the opposite direction.