December’s ECB verdict and sovereign yields

In the previous monetary policy committee meeting, the European Central bank (ECB) indicated that in December’s meeting some sort of movement in monetary policy would be communicated. In fact, as promised a change was announced yesterday and to a certain extent market reaction was positive. In addition, this week was also characterized by the Italian referendum, which led to the resignation of PM Renzi from his position following the humiliating defeat of a ‘No vote’ for reforms. Surprisingly, following the news, markets reacted positively and in fact we’ve experienced a building momentum to yesterday’s important ECB meeting.

In the build-up, markets were anxiously awaiting some form of further support by the ECB in re-assuring his presence through market operations in order to push the Eurozone towards his 2 per cent inflation target. Interestingly enough was the EUR/USD which traded flat on Wednesday, as traders awaited yesterday’s meeting, despite the surge of circa 2 per cent following Sunday’s referendum verdict in Italy.

Prior to yesterday’s meeting market participants were expecting the ECB to extend its QE program, in line with the yet to be achieved inflation level. Other than that, following the outcome the build-up towards the meeting was also justified as markets expected increased stimulus following the referendum outcome.

Thus the surprise was not the extended period till December 2017 of its quantitative easing (QE) program, but the reduction in monthly purchases from Eur80bn to Eur60bn. The initial market reaction was a spike in the EUR/USD which touched highs of 1.081. Despite the statement issued by the governing council always triggers initial market reaction, the press conference is a stronger element in terms of market movement. In fact, following the re-assurance from Draghi in the press conference that the ECB will intervene if necessary, apart from the fact that tapering wasn’t discussed unanimously, we saw a reversal in the EUR/USD towards the 1.063 level, as the market digested a dovish stance by the ECB.

In my previous writings, I had mentioned that the ECB is following the Federal Reserve’s path in terms of being data dependent. In fact, from yesterday’s comments Draghi was crystal clear to state that the ECB will once again re-tweak its program if market conditions deteriorate.

In my view, the recent movement in sovereign yields is justified due to the recent uptick in inflation. For the sake of clarity market participants always try to act in anticipation and the recent re-pricing yields is in line with the market expecting a reduction in QE going forward.

The other important decision taken by the ECB is the removal of the previous constraint in its asset purchasing program of not buying bonds which hold a yield below the -0.4 per cent deposit rate. This implies that the ECB will no longer be confronted with increasing long duration bonds on its balance sheet. This is also another point to consider seriously for investors holding long duration bonds. As a matter of fact, yesterday’s initial reaction were rising yields for bonds with maturities longer than 2-years.

Inflation forecasts by the ECB for 2019 are expected to be 1.7 per cent, thus still below 2 per cent. That said once again let’s highlight the important fact that markets commence pricing in anticipation and thus portfolio re-alignment is crucial.

Locally, investors who for the past years were faithful to local Malta Government stocks (MGS), which in actual fact provided strong capital gains, should by now have understood that what was experienced over the past years, is not sustainable going forward. For the first time in years, the Central Bank was bidding at levels below par for the latest 2.1 per cent 2039 issue. Understandably, the pricing was reflecting steeper sovereign curves in Europe as increased inflation expectations rose which in turn translate in monetary tightening. Thus, moving forward in my view it is imperative to primarily reduce long-dated MGS in order to avoid further capital depletion going forward.