1. ECB – No Taper Tantrum, Just a Taper Sulk
The headline was quite startling and caught the market unawares – “ECB said to near consensus on need to taper Quantitative Easing (QE) before it ends”. It came late last Tuesday afternoon, a day that had already seen Italy issue €5bn of 50-year debt, which is quite a sizeable chunk of duration to be absorbed by the market. So the market was already trading a bit heavy before it saw the ECB headlines. Whilst the immediate reaction was quite contained (a 5bps rise in 10-year yields), the trend continued over the course of the week, and 10-year German Bund yields finished the week in positive territory at 0.03%, up over 15bps from where they started the week. Market commentary immediately drew parallels with the infamous “taper tantrum” in the U.S. in mid-2013, when U.S. 10-year Treasury yields rose 140bps in the space of four months after U.S. Federal Reserve (Fed) Chairman Ben Bernanke hinted that the Fed might taper their QE programme. But we think such a reaction is unlikely for a number of reasons. Firstly, the ECB is nowhere near meeting its inflation target, nor is it likely, in our opinion, to come close to that target in the next 18 months. Secondly, there was nothing in the minutes of the ECB’s September meeting that indicated any discussion concerning tapering had occurred. Thirdly, the ECB minutes highlighted that current inflation forecasts are conditional on the current monetary policy stance and current market expectations about its future course. Fourthly, the comments were attributed to ECB officials rather than Governing Council members, and the comments were quickly refuted by both the ECB’s press officer and members of the Governing Council. It may be that the ECB were engaged in a “kite-flying” or “balloon-floating exercise”, which happens regularly in politics. Taking all the above into account, and the fact (as mentioned in this blog last week) that net government bond supply will be negative in Q4 2016 after taking into account ECB buying, we feel it is unlikely that the bond sell-off will go much further.
2. Brexit is Brexit
It was a pretty rotten week for Sterling last week, as it fell below levels seen in the immediate aftermath of the Brexit vote in late June. The UK press gleefully published headlines such as “31-year low for Sterling” as it depreciated against the U.S. Dollar to levels of 1.27, not seen since 1985. And then, in the early hours of Friday morning, Sterling experienced a “flash crash”, falling over 6% in less than 2 minutes. It did recover, but only to 1.24 and to 0.8950 against the Euro. It is likely that a wrongly entered order (or “fat finger”) triggered other stop-loss orders and automated algorithm trades exacerbated the fall. Either way, the effects of UK Prime Minister Theresa May’s hard-line stance on the UK’s exit from the EU is beginning to impact UK assets. The UK bond market is also feeling the pain – 10-year UK Gilt yields have risen by 45bps from their lows of 0.52% in mid-August. However, the sell-off has been even more pronounced in the UK inflation-protected market. In a move that ECB President Mario Draghi probably wishes he could see in Euro markets, the UK measure of 5-year inflation expectations in 5 years’ time has risen from a low of 2.90% at end-July to a current level of 3.60%. Of course, this is mainly due to the fall in Sterling this year, which should soon start feeding through into higher prices in coming months. Nevertheless, it does put UK Gilts in a difficult situation – higher inflation expectations mean a higher inflation premium should be built into bond yields. Higher inflation expectations also make it harder for the Bank of England (BoE) to ease monetary policy further, again undermining gilt valuations. Finally, Theresa May’s speech at the Conservative Party conference seemed to suggest that she disagrees with the BoE’s actions, and was more in favour of a fiscal response. A fiscal stimulus means increased Gilt issuance, putting upward pressure on Gilt yields. We believe all of the above factors argue for an ongoing underweight stance in both UK Gilts and Sterling.
3. Increased Volatility on the Horizon
As we come into the final quarter of the year, it seems that there is more uncertainty about politics and markets than in recent times. On the political side, we already talked above about how the UK Brexit situation is now increasingly becoming a hard Brexit scenario with all the uncertainty that it brings for trade and tariffs. In the U.S., we are entering the last month before the Presidential election and although Donald Trump’s prospects of winning have been affected by recent news flow, it is still probably too tight to call. In Italy, as we mentioned last week, Prime Minister Matteo Renzi faces a referendum on political reform that could make or break his political career. Recent polls show the “No” camp as having a slight majority, but a large proportion of the electorate are still undecided. From a markets perspective, we have two major central bank meetings in December. The Fed meet on December 13th and 14th, with markets anticipating roughly a 60% chance of a rate hike. Last Friday’s non-farm payrolls weren’t strong enough to guarantee a hike, but neither were they weak enough to rule out a hike. Before that, on the 8th of December the ECB will gather in Frankfurt to enjoy their Christmas party, but not before they make a keenly-awaited decision on whether or how to extend their QE Programme. Add in the traditional winding down of activity and liquidity in markets, and we have all the ingredients for potentially volatile markets. Despite the movements we saw last week in Sterling and global bond markets, Tanguy Le Saout (Head of Fixed Income, Europe) and the European Investment-Grade Fixed Income team still believe volatility is cheap, and being long volatility into year-end and early 2017 could be an attractive trade.