Central banks are preparing to change course

Mario Draghi’s 27 June speech (“Accompanying the economic recovery”) startled market participants awake from their day-dreams about their upcoming summer vacations. The 10-year Bund yield surged by 20bp on the week to 0.46% and the EUR/USD gained 2% to 1.14, a more than one-year high.

Draghi expressed his confidence in the inflation outlook, detailing the reasons why inflation is lagging behind the improvement in economic figures: the ongoing spillover of the fall in oil prices between mid-2014 and early 2016, structural changes in the labour market, and “backward-lookingness” in price and wage formation. Draghi struck a reassuring tone on the inflation outlook, saying that these various phenomenon would fade over time (by the way, Eurozone core inflation surprised on the upside in June to 1.1% yoy). But Draghi is no blissful optimist. He pointed out during his speech that the more favourable inflation dynamics were not yet on a self-sustaining path and that ECB policy should be “persistent”. But he did say 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.”

But, in fact, a real shift is occurring in central banks’ general orientations:

• The ECB will reduce its asset purchases in 2018.
• The Fed will shrink its balance sheet and continue raising interest rates, particularly for financial stability grounds (FOMC members have been increasingly vocal on this point).
• The Bank of England is pondering the relevance of a rate hike as the (perilous) negotiations on Brexit have just begun and the economy is slowing.
• The Bank of Canada has expressed it could raise its key rate very soon despite still very low oil prices.

Although inflation has not yet made a convincing comeback in developed economies, central banks will begin phasing out ultra-accommodative policies, as such policies are not without risks for the future. Keeping inter-est rates very low is fostering excessive leveraging (large US companies, US and UK consumer credit, Canadian housing credit). Low interest rates (and even negative in the euro zone) are undermining banking margins and encouraging the formation of asset price bubbles (for example, FOMC members regularly single out the commercial real estate market on this point). Euro and dollar corporate credit spreads are at five-year lows. In the ECB’s case, keeping asset purchases on their current pace in 2018 would soon raise implementation issues, and banks’ excess reserves are already over €1600bn. Is it really relevant to expand them further? This means that the amounts on which the banks pay a negative rate (-0.40%) keep climbing.

The shift in ECB policy will be one of the market’s guiding themes in H2 2017. As we saw this week, the shift will surely not be perfectly linear, but our view is that European rates will be higher and the euro stronger by yearend.