1. German Short-Dated Bonds Revisited
A couple of weeks ago in our blog we noted how the short-end of the German sovereign yield curve had become very expensive, and wondered if that richening, particularly against swaps, might reverse. Since then, there has been further debate over what is keeping German short-dated yields so negative and so low. Indeed, the whole topic was the subject of a recent speech by ECB Governing Council member Benoit Coure. Here are some of the reasons that are being advanced to explain the richness of German short-dated maturities:
- Non-Euro area banks and other investors do not have access to the ECB’s deposit facilities. These investors do not wish to place large amounts of cash with banks due to credit concerns, and so they buy short-dated German bonds.
- Concerns about the political outlook in France, Germany and Italy are pushing overseas institutional investors, reserve managers and foreign central banks to buy the safest asset in Europe i.e. short-dated German bonds.
- Heavy buying by central banks who have been trying to artificially hold their currency down, such as the Swiss National Bank and the Czech National Bank. These central banks have been heavy sellers of their domestic currencies, in turn buying Euro’s and parking the proceeds in German bonds.
- The ECB’s decision to allow the purchase of bonds yielding less than the deposit rate has seen a big shift in the buying pattern by the Bundesbank in particular. The weighted average maturity of bond purchases has fallen dramatically in recent months, from an average of over 9 years maturity in December to about 4.5 years now.
The message from Coure was that the ECB is aware of the distortions that the above factors are causing, but they are not minded (yet) to do anything about it. Therefore, it appears likely that the current richness of short-dated German bonds should continue.
2. ECB – “Oh Lord, Please Don’t Let Me Be Misunderstood”
In our last blog, we discussed the about-turn in ECB-speak about the “sequencing” of rate hikes versus tapering of bond purchases. That communication got notched up a bit higher this week at the ECB-watchers conference in Frankfurt, and by other ECB Governing Council speakers. Dutch central bank Governor Klass Knot was clear – “First tapering and only then raise the interest rate”. Knot noted he expected to see a rate hike soon after tapering has started, suggesting he was thinking Q1 2018 for the ECB’s first hike. Yves Mersch from Luxembourg, another member of the Governing Council, stated “all our instruments which are encompassed by forward guidance, whether it is interest rates or Quantitative Easing, are time and state-contingent”. This leaves open the possibility that if ECB staff economic forecasts are revised higher at coming meetings, then tapering could accelerate more quickly. The ECB Chief Economist Peter Praet, speaking at the ECB-watchers conference was adamant that “forward guidance implies a sequencing between the interest rate policy and the quantitative policy”. ECB President Mario Draghi spoke after Praet and said, “I do not see cause to deviate from the indications that we have consistently been providing”, but less than 3 hours later Bundesbank President Jens Weidmann raised eyebrows by saying that a discussion on forward guidance is “legitimate”. In what was perhaps a sign of frustration, another executive board member, Benoit Coure, warned that public disagreements might hamper the effectiveness of policy. At the moment, markets believe that the next tapering of ECB purchases could be announced in September and take effect at the start of 2018. If current strong economic conditions persist, the surprise could be a quicker taper, and an earlier deposit rate increase.
3. Czech Out How to Dismantle A Currency Peg
There is a lot of debate about the merits of currency pegs, and the associated cost of maintaining those pegs. Many people are familiar with the Bretton Woods system, introduced towards the end of World War II that tied currencies to the price of gold. That system lasted until 1971. Then there was the pre-cursor to the Euro, known as the Exchange Rate Mechanism (ERM). This was a system whereby currencies floated in a tight range (usually +/- 2.25% but certain countries were allowed a 6% fluctuation band) around agreed bilateral rates. People of a certain vintage will remember “Black Wednesday” – September 16th 1992, when pressure on Sterling became too great and it had to leave the ERM. George Soros, a hedge fund manager was rumoured to have made GBP£1 billion profit from that decision, and he became known as the “man who broke the Bank of England”. More recently, the Swiss National Bank’s decision to scrap its currency peg against the Euro in 2015 caused huge volatility, and a 41% appreciation (at one stage) of the Swiss Franc. So last week’s announcement by the Czech national bank that they were ending their currency cap had the potential to cause waves in FX markets. In the end, the decision only caused ripples. The cap was introduced in 2013 to prevent the Koruna from appreciating past 27 to the Euro, at a time when the Central Bank was trying to avoid deflation. But with inflation on the rise again, and now exceeding 2%, the Central Bank had signalled that it would eventually abandon the peg and return to more conventional policy. Indeed, the Central Bank’s official commitment to maintaining the peg expired at the end of March. Bloomberg have estimated that investors had bought an estimated US$65bn of local assets in the hope of a strong rally in the Koruna after the cap was removed. By close of business last Friday, the Koruna had rallied to 26.57, a gain of only 1.7%. Whilst the potential for Koruna appreciation remains, there are many investors that may be disappointed by the lack of gains, and who may now look to exit their positions.