The general market perception of the European economy is of a slow-growing, inefficient economy that would benefit greatly from structural reforms. It was therefore a considerable surprise when the Q1 2016 GDP released last Friday, showed that the Euro area had grown by 0.6% on a quarterly basis, or 2.2% on an annualised basis. This was the joint strongest in the currency economic cycle, and almost double what is widely considered the area’s trend growth rate, whilst expectations had been for a 0.4% print. Domestic demand appears to have been the big driver of the improvement, which bodes well for the economy going forward, whilst exports look to have slowed significantly – no real surprise given the state of the global economy. Bear in mind that the growth rate in the U.S. for the same period was only 0.5% quarter on quarter, so the Euro-area is out-pacing the U.S. Unfortunately, before the ECB could pat themselves on the back for a job well done, the latest inflation numbers showed that European inflation fell back into negative territory, printing at -0.2% for April, below market expectations. Equally disappointing was the fact that core inflation fell back to 0.8%, again below expectations and below the average for H2 2015. The complete lack of inflationary pressures will be a cause of significant worry to the ECB. Whilst inflation break-evens are currently at attractive levels, we still need to see some catalyst to push them higher before implementing any long positions.
2. Bank of Japan – Not Learning from the ECB’s Mistakes
The December 2015 ECB meeting will be remembered as a classic miscommunications episode. In the run-up to the meeting, market participants gradually raised their expectations for what would be announced, only to be disappointed by the ECB, sparking a period of considerable volatility and head scratching. In subsequent briefings and meetings, the ECB have admitted that they should have attempted to calm market expectations ahead of that meeting. Last week’s Bank of Japan (BoJ) meeting followed almost exactly the same playbook. Following their surprise decision in January to introduce negative rates on bank deposits, yields on 10-year Japanese Government Bonds (JGB’s) fell into negative territory, whilst the yield curve flattened its 30-year JGB yields falling as low as 0.40%. Surprisingly, the Japanese Yen rallied strongly, appreciating almost 8%. Prior to last week’s meeting, market participants and commentators had been moving towards expecting further actions from the BoJ, especially as the Japanese Yen has appreciated strongly since that January BoJ meeting. In the end, however, the BoJ did nothing, leaving markets confused, especially since they revised down their 2016 inflation expectations from 0.8% to 0.5%. Understandably, the Yen continued to rally, the equity market sold off, but the bond market actually rallied. Yields are now lower than before the meeting, and the yield curve continues to flatten. Expectations are already growing for the next Bank of Japan meeting in June, but it may be that the focus will turn to fiscal stimulus packages. There have been many stimulus packages over the years, none of which have been successful. Currently, over 70% of all JGB’s have negative yields and the BoJ is buying 80 trillion yen worth of bonds every year – a powerful downward force on yields. We still think 10-year JGB yields offer no fundamental value, and continue to believe in a short duration position.
3. Reserve Bank of Australia – Tough Call
Further evidence of the global disinflationary backdrop was seen in the surprisingly low Australian Q1 2016 inflation numbers. Whilst the markets were expecting a 1.7% increase, the number printed at 1.3%, well below the Reserve Bank of Australia’s (RBA) target of 2%-3%. Previous misses have been characterised by the RBA as “temporary”, but the scale of this miss makes it more difficult to pass it off as a “temporary” event. This was the weakest quarterly headline Consumer Price Index reading in 7 years. The breath of the price weakness, and signs that inflation expectations are shifting downwards, will also concern the RBA. However, the general economic outlook appears reasonable, with growth running around trend and unemployment at 5.7%. All of which puts the RBA in a quandary when they meet on May 3rd to discuss monetary policy. Generally, the RBA receives new economic forecasts before their meetings in February, May, August and November each year, suggesting that they are more likely to change policy settings at one of these four meetings. Indeed, in the past ten years (2006-2015), the RBA has changed its policy rate five times at a May meeting, meaning there is historically a 50% chance of a rate change in May. That is considerably higher than the probability of a rate change at any monthly meeting, which is 27% (30 changes in 110 meetings). Bear in mind also that Australia is facing a national election on July 2nd, and as of yet no successor has been announced for current RBA Governor Glenn Stevens, whose term will end in September 2016. Prior to last week’s inflation print, our view was that the RBA were likely to remain on hold at this week’s meeting, but last week’s number and the calendar outlined above make it much more of a 50/50 decision. Accordingly, we have reverted to a largely neutral stance on Australian yields, although we still prefer to overweight Australia versus the U.S.