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26 Jan 2018

Baton passed: Comment on the European Central Bank monthly meeting

“It would appear that, after many years of central bankers’ largesse, their omnipotence is fading as economic fundamentals take centre stage."

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Nicholas Wall, portfolio manager, Old Mutual Strategic Absolute Return Bond Fund, Old Mutual Global Investors

“It would appear that, after many years of central bankers’ largesse, their omnipotence is fading as economic fundamentals take centre stage. While European Central Bank (ECB) president, Mario Draghi, raised concerns about euro volatility, short of all-out currency wars, there is little he can do to contain the currency’s strength when the growth outlook is so positive.

“European government bond yields are also trying to escape from their financially-repressed low levels. The market is anticipating the end of quantitative easing as the hurdle rate for additional asset purchases in September seems very high now – it would take a downturn in growth or a rapid drop in inflation expectations, something we don’t envisage right now.

 “Europe is growing beyond its potential (based on population growth and productivity) and unemployment is dropping. As a result, we expect inflation to pick up this year and increase the pressure on the ECB to end quantitative easing (QE). The Phillips Curve, with Europe’s more unionised workforce, may also be less flat than in the US – watch the German wage negotiations for whether labour can successfully demand a larger share of the national income. While, normalisation of central bank policy is healthy and is a reflection of the impressive recovery that ECB president Draghi has overseen – it is not without risks.

 “Low, and often negative, interest rates have permeated through all asset classes. As the risk free rate rises it will put pressure on the search for yield strategies that have seen huge inflows in recent years, whether that’s in corporate bonds, high dividend equities or real estate.

 “The huge ECB buying programme has also resulted in massive capital outflows from Europe into US and UK bond markets. As European yields rise and it becomes more attractive to repatriate capital held abroad, term premium US Treasuries and Gilts should increase – yields will sell off here too, and curves should typically steepen.”

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