It feels like a long six weeks since the ECB Governing Council’s last monetary policy statement. The usual summer lull has been definitely absent this year, with further China-led events following on the heels of Greece and commodity prices to inject volatility and uncertainty into financial markets.
First, the People’s Bank of China took the FX market by surprise mid-August, moving marginally closer to a market-based exchange rate. It moved the fixing rate almost 2% higher on 11th August, effecting the currency’s biggest one-day devaluation since 19941, and seems more comfortable with greater daily volatility in the exchange rate.
Secondly, a dramatic selloff in Chinese equities prompted large moves in global stock markets and a spike in the VIX. For fixed income investors, while high quality sovereign bonds remained relatively stable, high yield and emerging market bond yields widened significantly.
Fears of worsening Chinese economic growth have added to uncertainty about the potential start date of interest rate normalisation from the US Federal Reserve. We retain our view that the Fed will commence normalisation this year and are still positioned for a flattening of the US treasury curve, including a short or underweight position in the front end. September 17th is still a possibility, with nothing from the Jackson Hole Symposium last weekend categorically ruling it out. However, the market is currently giving this less than a 40% probability2.
The risk to the yield curve flattening view is real. If the Fed reacts to the fall in commodity prices and decline in global economic growth by keeping monetary policy on hold through 2015 and at the same time, because of the same fall in commodity prices and slowing global growth emerging market central banks liquidate their Treasury holdings in the course of reserve management, the combination of these two forces could cause the US yield curves to steepen.
The Reserve Bank of Australia (RBA) kept the cash rate unchanged this week at 2%. In the statement the RBA noted “further softening conditions in China” and “Australia’s terms of trade are falling”. We remain short the Australian dollar and are marginally long Australian government bonds.
The ECB maintained its refinancing rate at the record low 0.05%. Overall, President Draghi struck a relatively dovish tone, referencing the lower oil price and impact of lower external demand from weaker emerging markets growth several times. In addition, he cited market volatility since the finalisation of staff forecasts as a factor in deciding monetary policy. We were surprised that the ECB would focus on such volatile and near-term indicators.
The ECB staff forecasts for real GDP growth and inflation for the single currency bloc over the next two-and-a-half-years have all been revised down. Growth and inflation are now predicted to be 1.4% and 0.2% respectively for 2015. Next year the economy is expected to grow 1.7% with a rise in inflation to 1.1% and, finally, inflation is forecast to rise to 1.7% in 2017 with GDP growth of 1.8%.
While commenting that inflation could turn negative in the coming months, Draghi also noted that the decline in oil prices should ultimately provide support for private consumption and investment.
The most surprising announcement was the increase in the issue share limit of a country’s debt that can be purchased in the QE programme, up from 25% to 33%.
Within the eurozone we retain our preference for Portuguese and Slovenian government debt.
Finally, in the foreign exchange space we remain short JPY against USD. In emerging markets we are long a basket of currencies including ZAR, MXN, INR and IDR but remain short BRL. Following several interest rate hikes the central bank of Brazil kept the Selic rate unchanged this week at 14.25%.
Source: Bloomberg August 2015
Source: Bloomberg September 2015
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