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The European Central Bank (ECB) finally made the move and cut official interest rates, its first policy change since November 2000 and the first easing since January 1999. However, unlike the positive bond market reception to easing moves from central banks elsewhere in the world, the mood that greeted this cut was less than joyful.
For some investors this move, although in the right direction as far as the future well-being of the European economy is concerned, has further damaged the credibility of the ECB and as such could be harmful to both the bond markets and indeed the frail euro. Peter Van Doesburg, strategist at Kempen & Co in Amsterdam, explains, “This move is very strange in the light of the inflation-targeting regime the ECB pretends to follow. It inflation is still high and is not edging downwards as the ECB suggests. It looks to me like internal disagreement between council members is spreading.”
For Van Doesburg, this internal strife worsens the low esteem in which investors hold them. “The credibility of the ECB is at an all-time low; low predictability, conflicting signals and a complete lack of transparency concerning their plans to optimise long-term growth all add to the serious misgivings about the ECB. That’s why we think the euro remains under pressure. And if they have made the shift from hawk to dove then why not do it more forcefully?”
Van Doesburg suggests that the US Federal Reserve has been able to “move with the times” and has shifted its aims and targets and the US economy and the general environment have changed, in particular the central belief that inflation is not the problem it was 20 years ago. He goes on, “The ECB still has the old rules. When it cut rates in April 1999, it was looking at the improving inflation picture, but ignoring the fact that the economic growth was picking up. Inflation was low because of the fallout from the Asian crisis. It had to reverse the cut before the end of the year. Their 0–2% target range is plainly too low and too narrow, and makes it so awkward to steer a path through it.”
Even those investors who had predicted an imminent move suspect the ECB’s motives. “We were expecting a pre-summer move from the ECB,” says Roland Lescure of CDC Ixis Asset Management in Paris, “mainly because we were worried about growth prospects and we thought that sooner or later the ECB would have to acknowledge the disinflationary effects of the slowdown. The ECB appears to be announcing the statistical revision to the M3 more as an alibi than as a real justification for the rate cut; inflationary risk has not suddenly disappeared thanks to some magical change in the statistics.” He suggests that the real story behind the move is that this time the doves were successful in persuading the hawks that growth should be more of a worry than inflation.
And the managers at Julius Baer voice their dissatisfaction too. “The ECB are managing policy with a rear view mirror,’ says Edward Dove, head of fixed income in London, adding, “And if they are not careful, inflation will indeed fall rapidly below the 2% level as, through their inertia, the economy is ground down because monetary policy has been kept too high. Our work shows that core inflation in Europe is already a lot lower than headline and that it should not be appearing on any of the ECB’s radar screens.”
“Of course the most important thing now is that they have acted,” says Lescure, “but timing matters. Being one or two months late does not change much on the fundamental issue of growth and inflation prospects over the next 18 months, but we feel that being late again – after April 1999’s 50 basis point cut, then the 50 basis point hike in November coming six months after the ECB had started hinting that a change in policy was coming – all adds up to a sense of diminished rather than enhanced credibility.”
Aside from the prospects for the euro which many investors agree are uncomfortably closely linked to the ECB’s stature as a respected central bank, it would appear that European government bonds might offer better value than US Treasuries, in local currency terms at least. Dove comments, “We are heavily overweight European bonds, but we have hedged out of the Euro exposure. We are generally not taking big currency bets now, because currency markets are too fickle. We are very positive on inflation and think that the long end offers best value.”
Dove goes on to explain that Baer’s US portfolios are also positioned long of the duration benchmarks, not least because of its view that US economic news will get worse before it gets better. He explains, “Bond yields have risen quite sharply as equity markets have rallied in response to Fed chairman Greenspan’s rate cuts, and we now think long yields offer value.” The managers at Julius Baer are quite cautious on credit and sticking with AA/AAA-rated bonds, suggesting that to go much lower is too risky at this juncture. They are, however investing in some sub-investment grade paper, but these are specific issues selected by strict bottom-up analysis, rather than a top-down macro view on the sector as a whole.
CDC’s Lescure agrees that US economic news, in the form of weak profit announcements, should bring the stock market down a little, which will probably support the bond market. “But the trough in US rates is probably not far away,” he says, “whereas in Europe the slowdown has just begun. We expect 10-year US Treasuries to bottom out at around 5–5.1%, but that German bund yields could decline to around 4.75%.”

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