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It’s already been a hot summer on the bond markets

The repercussions of Mario Draghi’s speech on 27 June (“Accompanying the recovery”) continue to be felt on the bond markets. The German 10-year yield climbed 11 bp this week to reach 0.57%, its highest level since the very beginning of 2016.

 

The ECB has very clearly marked a shift in its communication in recent  days. As a reminder, while choosing his words with care, Mario Draghi expressed his confidence in the inflation outlook. In particular, he indicated that “as the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments.” This week, it was the governor of the Bank of France who indicated that accommodative monetary policy was “effective”, but“not eternal, or omnipotent”, and that “nominal rates tend to increase based on the economic recovery and inflation.” The minutes from the most recent Governing Council meeting pointed to consideration of whether to withdraw the easing bias attached to the QE programme (ie withdraw the option to increase its size and duration).

Indeed, there are obstacles in the ECB’s path, with the appreciating euro and falling oil prices. The effective euro exchange rate tracked by the ECB (a basket of 38 currencies known as the EER 38) returned to its highest levels since the summer of 2014, a period that preceded the ECB’s QE announcement. Above all, the euro is now 2.3% higher than it was when the most recent economic projections were made (the 2018 inflation forecast had already been reduced from 1.6% to 1.3%) and the price of Brent is 5% lower. If things were to remain the same, the 2018 inflation forecasts would be revised downward once again.

However, it is the core inflation trend that will determine how the ECB acts and above all its conviction that the economy (and the labour market in particular) is on the right track. We should recall when Ben Bernanke spoke about the Fed “tapering” its QE in May 2013, core inflation was only 1.4% and slowing down. It is first and foremost the solid trend in the economy and the labour market that caused the Fed to “recalibrate” its monetary policy.

What can we make of these market trends?

  • The marked fading of political risk in Europe and the abandon of the idea of further cuts to deposit rates have allowed German short rates to recover since early June. This trend will continue over the coming months. 
  • The markets were too pessimistic over the outlook for fed fund rate hikes over the next 18 months, and they still are (only two increases are being priced in between now and the end of 2018). The bond sell-off also comes from the rather hawkish tone of the FOMC minutes published this week.
  • Inflation breakevens remain much too low in Europe and will increase thanks to rising core inflation over the coming months.
  • The steepening of the short end of the curve is consistent with upcoming, but not yet imminent, monetary policy normalisation.
  • A positive factor against this backdrop of rising long rates is seeing that spreads (peripheral, credit) remain broadly stable, but a return to a more fundamental valuation would impact certain countries.

Ultimately, this trend has good reason to continue for a while longer yet. Benoit Coeuré explained on Wednesday that “he didn’t think that this type of market reaction was particularly significant when looking at the bigger picture, especially with the economic forces at work.” However, the ECB will surely calm things down if rates rise too far too fast.

 

 

2017-07-07-key focus

 

Bastien DRUT, Strategy and Economic Research at Amundi
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It’s already been a hot summer on the bond markets
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