The big picture
ECB president Draghi is certainly making a name for himself with his market-jolting, memorable speeches. In 2012, his strident call that the euro would be saved “whatever it takes” marked, or arguably triggered, Europe’s move out of its crisis. In August, Draghi made a speech in Jackson Hole that surprised many with the nature some of its statements, in particular his opining on Europe’s fiscal policy.
Draghi referred to how the US had benefitted from delaying fiscal tightening until its economy was stronger, suggesting that Europe’s politicians perhaps need to re-think their highly restrictive fiscal policies. Coming from a central bank that follows the model of the Bundesbank – highly conservative in terms of holding to budget limits – this was dramatic talk indeed.
US economic growth remains intact, with many now predicting that it could become the longest US expansion ever recorded. This economic cycle has other features that distinguish it markedly from previous ones, not least in the length of time it is taking the world to deleverage after the 2008 financial crisis.
Economic cycles can be de-railed by a variety of factors. Often there has been a huge degree of synchronisation across the world, creating excess demand and subsequent over-heating. However, this cycle is also notable for the fact that so many of the world’s economic areas are at very different stages and, even more unusually, that the biggest gap is within developed markets, as the US appears to be so far ahead of Europe.
Throughout this year, geopolitical issues have come to the fore, such as the Russia-Ukraine crisis, Gaza and now the growing violence in Iraq, Syria and other troubled countries within the Middle East. To date, markets have appeared to be quite sanguine about the risks. However, as well as following Bund yields lower in anticipation of looser European monetary policy, it is likely that US Treasuries have also benefitted directly from the worsening crisis in Ukraine over the summer, in a definite ‘risk-off’ move.
Focus: Inflation expectations
In his Jackson Hole speech this summer, ECB president Draghi made specific reference to European five-year inflation in five years’ time (the 5Y5Y forward), saying that its recent decline below 2% was something that the ECB council would have to ‘acknowledge’. Markets interpreted this as a strong hint that the ECB’s monetary policy would be eased further, which duly took place in early September.
Draghi has talked before about the potential for a “pernicious negative spiral” should low inflation expectations become entrenched. Negative inflation, or deflation, is dreaded by economic policy makers – none more than some of Europe’s most heavily indebted nations.
Since early 2011, European inflation expectations at all maturities have been falling. Five-year inflation expectations breached the ECB’s key 2% level first, followed by 10-year expectations in 2013. Then in June of this year, the 5Y5Y forward also lurched below 2%, which triggered Draghi’s comments at Jackson Hole.
Inflation expectations, whether measured by inflation swaps or calculated from inflation-linked bonds, are always difficult to interpret and can, on occasion, be overly influenced by realised inflation data. However, what happened this summer was something rather more serious.
Longer-dated break-evens (break-even inflation rates) have often appeared to ‘over-react’ to falls in break-evens at the shorter end, but would then gradually move back up. However, they carried on trending lower in June, breaking new records. It became evident that longer-dated measures of inflation were becoming highly sensitive to trends at the shorter end, and that there was a real danger that the contagion appeared to be worsening.
The ECB seems to have taken this ‘threat’ seriously, given Draghi’s direct reference to inflation expectations at Jackson Hole. Erroneous though the signals from longer-dated forward inflation swaps often are, keeping a close watch on underlying trends and patterns, can evidently provide extremely valuable insights.
Although Treasury and Bund 10-year yields both moved lower over the course of this year, the gap between them has continued to widen, with Bund yields grinding even lower in the face of disappointing economic growth and, importantly, price data pointing to ever lower inflation prospects.
After September’s ECB meeting, it has become clear that the world’s biggest central banks are no longer moving in synchronisation. There is no overwhelming consensus as to when the Fed will hike rates; bond markets have notoriously short horizons and while asset purchases may be ended as early as October, the fact that rate increases might not take place until later in 2015 means hikes are still far away enough for bond markets to not get fixated yet.
September’s announcements of ECB easing have left many still wondering whether there could, or should, be more. The possibility of European QE is being hotly discussed, but with no sign yet that the ECB is even contemplating such a move.
With its multitude of jurisdictions, there are some high hurdles to negotiate before the ECB could embark upon this unconventional easing. In addition, many are asking what QE could achieve with (European) bond yields already so low across the maturity spectrum.
As for Treasuries, the focus is very much on the steepness of the yield curve, particularly in the belly, the fives to 10s. In ‘normal’ rate hiking circumstances, yield curves tend to flatten as the shorter end starts to discount higher official rates before longer rates. There seems to be far less of a ‘predictable’ pattern for rates at maturities of 10 years and longer.
Just as the US bond market is benefitting from an underlying flight to quality on rising geopolitical tensions, so too is the US currency. But the bullish macro-economic outlook for the US dollar also remains intact, aided by the ECB surprises as well as a steady flow of reasonably upbeat domestic economic data. The widening spread between short-dated Treasuries and European bond yields is already providing the dollar with significant support versus the euro.
With less co-ordination between the major central banks’ monetary policy actions, widening interest rate spreads will most likely produce more scope for FX divergences too. For a few EM economies, the prospect of a weaker currency might be welcome but, for some, especially those whose reform efforts have perhaps stalled and who still rely heavily on foreign capital and US dollars in particular, the prospect of the Fed turning the liquidity tap off holds considerable challenges. That EM currencies trade closely with US Treasury yields, and have no relationship with European yields, is a direct function on the primarily dollar-denominated funding requirements of the EM universe
China is making progress, if rather slowly, on its capital market reforms. In October, the Shanghai-Hong Kong Stock Connect scheme (SHKSC) will be opened, giving international investors a new portal via which to gain exposure to Chinese equities.
Although capital account reform is happening, there is frustration at the slow progress. In 2013, the renminbi made it as one of the top 10 most highly traded currencies in the world. However, while China accounts for 10-12% of total global trade, the Chinese currency accounts for only 2% of global foreign exchange turnover.