NO 'BAZOOKA' FROM THE EUROPEAN CENTRAL BANK

The 70th anniversary celebrations of WWII D-day marked the week's historic dimension for the broader public, while capital markets noted the first time that any major central bank has taken interest rates negative. The European Central Bank (ECB) cut interest rates by a very incremental 0.1%, which took the rate at which commercial banks can park their cash surpluses with the Central Bank from 0% to -0.1%, meaning their deposits gradually shrink rather than grow. The rate at which banks can borrow from the ECB for the short term was lowered from 0.25% to 0.15%. While technically marking a historical point (although Denmark recently experimented with a negative rate on a smaller scale), the move is in my opinion more aimed at making a statement rather than making much of a difference. Here is why: In theory the negative rate should encourage banks to lend out the money, rather than deposit it with the central bank and also to pass the negative rate on to their customers, thereby encouraging those to spend the money or invest it. In practice, banks will not be able to pass on the negative rate to privates (because they may choose to hold the deposits in actual notes in safe deposit boxes) or corporates. On the contrary they may increase rather than decrease what they charge for short term loans in order to recover what they lose on their cash surpluses with the central bank. In any case, at such a small scale of change (0.1%!) any real effect ought to be marginal, unless market participants see it as a signal for a change in direction. In this respect - for the readers of the fine print – there were some signs that the ECB may have overcome Germany's past rejection to conduct outright quantitative easing (QE) – more about this further below. Because of the lack of any real surprises, beyond what had been widely expected after specific hints last month, markets appeared underwhelmed and just continued where they had left off before the announcement. This was a gradual advance of stock markets, taking them in the case of Germany and the US to new historical highs, while the UK's is still struggling with the FTSE's 7,000 mark (reminding me of the struggle with the 6,000 mark over the course of 2012!).

Bond yields had finally been moving in parallel to equity markets, until US job market data on Friday came in slightly mediocre (but as expected). This put downward pressure again on yields because bond markets appear to be ricocheting between their own belief that the economy is expanding at a higher rate than Central Banks like to admit which will see rates go up much sooner than advised and on the other hand agreeing with central bankers' view that the expansion is still quite pedestrian, which will not warrant rate rises at least until the middle of 2015 and then only very gradually. The US job growth number aligned with the latter scenario and as a result equity markets and bond markets moved up again in unison in expectation of continued cheap credit fuel.

Economic outlook data from the UK services and construction sectors provided continued evidence of the persistency of the UK's economic revival. At the same time Nationwide's house price index reading showed a slowing of the growth rate compared to April, however, this still makes an unsustainable annual growth rate of 11%. Unsustainable not because current mortgage costs are decimating UK homeowners' disposable incomes – they are not - no more than the historical average anyway, see our special at the end – but because they have the potential to become a formidable millstone for consumers in the future, when interest rates eventually have to rise. This is unless the economy can continue to grow unconstrained of fears of premature rate rises which should finally feed into improving real wages, making higher mortgage burdens less threatening.  We therefore expect the Bank of England to make further use of their macro prudential intervention toolbox fairly soon and force banks to put even higher minimum requirements in the way of mortgage seekers, but leave rates unchanged. It can also not be long now before the government will have to restrict the second part of its Help to Buy scheme of mortgage guarantees for any home purchase to just new builds.

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EQUITIES AND BONDS ARE BOTH RISING – ONE OF THEM HAS TO BE WRONG!

The 2014 government bond conundrum continues: Bonds and equities continued to rise in unison, while economic logic and history suggests that they should move against each other. The chart above illustrates this through the comparison between stock market moves and yield changes (which move inverse to bond values). Normally when stock markets rise, bond yields rise as well. This is the result of selling pressure on the lower risk, lower return potential bonds in favour of equities, which drives down bond values. This reduced value increases the relative yield their fixed coupons payments constitute vs the market value of the bond.

Since the beginning of 2014 this rationale appears to have broken down and particularly in the past weeks yields have fallen, bond values rallied while stock markets have also reached new highs. So the question many market players are asking is: Who is wrong (and therefor in for a fall) the bond markets or the stock markets?

There are a number of explanations for what we are experiencing:

1.    A previously failing economy is recovering, reversing earlier parallel falls of equities and bonds

2.    Bond investors foresee trouble that equity investors don’t see

3.    Markets expect quantitative easing measures in the future, driving up bond demand and pushing investors up the risk curve into equities

4.    Correction of a previous overreaction of inflation fears by bond investors

5.    Fiscal repression: Financial institutions are ‘forced’ to purchase government bonds

 

All of the above are currently hotly debated and as stated before, I believe that we are experiencing a temporary correction of bond yields after bond investors have come to realise that inflation is going to rise less quickly than they anticipated during the 2013 government bond sell off. As always it is most likely not a single reason explaining market action. There are good arguments that banks, insurers and pension funds are forced by regulation to stock up their government bond holdings, while there is a supply shortage as governments are borrowing less and central banks are still holding vast amounts of the existing stock as a consequence of their QE programs. There is a bit of fear as well, resulting from the disappointing Q1 growth figures around the world, which some interpret as the harbinger of a turning of the economic cycle, while most see it as a temporary blip as a result of adverse weather in the Northern hemisphere.

During the past week, argument 3 received some additional support, when Eurozone money supply figures showed that the monetary base in the currency union is still shrinking (see chart below), while the economy is clearly expanding once again. This has made additional monetary easing by the ECB all but a certainty, following their announcement last month that they would do so in their next meeting should the deflationary pressures persist.

 

I somewhat suspect that markets are overestimating the likely ECB announcement for Thursday next week. Clearly there will be some sort of action, but I believe it far more likely that the first step will be a tinkering with the already low interest rates towards an experiment with marginally negative rates for bank deposits. In combination with the further improving macroeconomic environment I am expecting the ‘bond-conundrum’ of 2014 to pass in the foreseeable future. So bonds are the asset class more likely to retreat over the summer, however that is not to say they are wrong at the moment, but rather that they were wrong last year, when they fell far more than the slow economic progress warranted.

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