Realisation that the ECB is behind the curve
The recent soft economic data such as inflation and PMI readings has led the market to believe that the European Central Bank (ECB) would do more. We felt that it was going to be too soon for them to announce anything new and that they would focus on the planned Covered bond and ABS buying program.
Ever since this initiative was announced Draghi has been reluctant to suggest the ultimate size of the program and has continued with that theme yesterday. This is partly because there are too many variables – size of new and existing issues and the demand for the program. This lack of information together with the low take up of the new TLRTO is disappointing the markets.
We believe they will need to do more as economy requires further stimulus whether this comes in the form of direct QE into government bonds is still open to debate due to prior German resistance to the idea. At the very least it opens up the chances of less fiscal restraint which ultimately could prove beneficial.
For bond markets the initial disappointment will give way to a realisation that the ECB will have to continue to increase the size of its balance sheet but that the details of how this will occur may not be known for a while.
Bond yields will continue to trend lower and spreads should eventually narrow. The current ‘risk off’ phase is more widespread than just Europe and is producing a period of weakness for corporate and EM bonds. This phase is unlikely to be reversed by yesterday’s lacklustre showing by the ECB.
A weak economy and a slowing expanding central bank balance sheet will undermine the Euro especially against the US Dollar. The US is stopping its balance expansion and has a better economic outlook. This trend has been in place for a few months but should have further to go on a realisation that the ECB is behind the curve.
Paul Brain, Leader, Fixed Income at Newton Investment Management