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The ECB Governing Council announced that it will adjust its PEPP (Pandemic Emergency Purchase Program) bond buying towards ‘a moderately lower pace’. Expect a drop from EUR 80 billion a month towards EUR 65-70 billion. Market observers warn that such a decision is inconsistent with the strategy review of last July that pointed to ‘forceful or persistent’ monetary policy measures in order to avoid negative deviations from the inflation target. Such deviations should not become entrenched. However, the press conference did not reveal anything that should create concern at this moment. First, the ECB adjusted their 2023 inflation estimate towards 1.5% from 1.4%. They simultaneously raised their 2021 GDP growth number to 5%. Second, over the past 6 months, the ECB has flagged that they would use the full PEPP envelope by March 2022. They are still well on track. Third, the flexibility they preached since the outbreak of the pandemic is still intact. I conclude that the path of least resistance will lead them to adjust the overall asset purchase program beyond March 2022 in line with the conditions that will prevail over the winter months end of 2021 and early 2022. The fact that the ECB does not want to commit too early to communicating about ECB QE life after March 2022 is due to the current high intensity of their interventionist policy. President Lagarde stated that we should be patient and the ECB would inform us during the December 16 press conference. In the meantime, the implicit yield curve control is well in place. The combined EMU Government Bond market and the Investment Grade Corporate bond market are quasi under full control of the ECB QE program. The signalling function of risk-free rates towards the economic and credit cycle has long made an exit. Taken from a distance, we sense that the overall ECB communication breathes anxiety. Anxiety to make a policy mistake within a European construct (+ a heavy political election calendar) that reveals many fault lines. Anxiety due to the premature release of the monetary policy review back in July. The contours of the policy review leave too much room for interpretation. The uncertainty about the results of the inflation (HICP) analysis running till 2025 (model risk of bringing housing costs into the HICP basket), makes the reading of the new 2% flat inflation target a highly sensitive exercise. As a result, the discussion among bond managers shifts away from ‘level of rates’ towards ‘shape of the yield curve’. Indeed, the level of term premia across maturities takes centre stage. With official policy rates well anchored at -0.50% and an ever-increasing portion of outstanding EGB’s and corporate bonds on the ECB’s balance sheet, investors become less worried about direction of 10-year rates but more about the rate differentials between 5, 10 and 30-year government bonds. But are we missing out on other scenarios? Maybe…
Notwithstanding a similar picture of deeply negative real rates across the EU and the US, the impact for savers confronted with negative EU policy rates versus US zero policy rates is stark. By now, most EU banks have decided to burden savings by imposing the -0.50% penalty above a certain threshold. That will drive more and more households towards forced investment into real estate and/or financial markets. Without correct macroprudential measures in place, this behaviour can lead to overheating of housing markets and more froth in specific sectors of public equity markets. Central banks in Australia and New-Zealand are experimenting with harsher macroprudential measure to cool down the housing market…to no avail so far.The moment the ECB starts mentioning the above risks we might find a concoction of circumstances that might lead to an EU rates tantrum. A tantrum that is NOT based on an ECB taper path but based on an earlier return to 0.00% deposit rates. The debate around the ‘reversal rate’ has gone out of fashion lately but requires a refresh visit. Indeed, reaching sustainable medium-term growth rates across the Eurozone, the ECB should reflect on the benefits of the correct signal that accompanies saying goodbye to the negative interest rate policy. The Swedish central bank lifted policy rates twice from -0.50% to 0.00% in early 2019 and 2020. The pandemic did not warrant a return to -0.50%. The Swedish monetary doctrine and framework deserves some attention in Frankfurt.
When the ECB characterisation leads us to ‘anxious’, we arrive at ‘confident’ for the US FED. The US central bank did not want to get cornered by using a calendar-based approach to monetary policy and instead opted to communicate based on average inflation and maximum, inclusive, employment targets. The initial market response led to a short-lived mini tantrum between November 2020 and March 2021. The clear priority setting by the FED, in favour of labour market healing, led to a Treasury market that was not impressed by a series of high producer and consumer inflation prints. These were translated by lower real rates across the maturity spectrum. Especially at the short end, where 1-year and 2-year real TIPS rates change hands at around -3.10% and -2.70% respectively.
Emerging Market (EM) central banks have interpreted the surge of domestic inflation over the past 6 months as a non-transitory event. Most decided to hike policy rates pre-emptively. Yes, the pandemic lifted indebtedness. Yes, food inflation heavily impacts household purchasing power. Yes, vaccination progress is lagging far behind developed markets. But EM markets are ahead of better corona seasonality. Growth recovery is intact. Disappointment relates to lack of pace rather than lack of opportunity. Effectively, current account deficits improved markedly. IMF SFD support (Special Drawing Rights) protects fiscal accounts. Such pre-emptive monetary policy has stabilised EM currencies whilst pushing interest rate differentials against US Treasury rates to cycle highs. The contrast between the situation in 2013 and today is evident. Back then, Ben Bernanke’s taper communication error led to a multi-year EM economic slump and a distinct bear market episode across EM debt. EM government debt has been recovering since August 23. August 2021 might be remembered as what March 2021 was for US rates: a buying opportunity. Time will tell.