The liquidity hallmark

Good morning!

The European Central Bank (ECB) concluded its monetary policy meeting yesterday without surprises but with a renewed commitment of intervening as needed in the markets until “we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term”. As yet another proof of its confidence in the new stimulus program consisting mainly in government bond buying (Quantitative Easing, QE), the bank revised it growth projection upwards although it reckoned that “the risks surrounding the economic outlook for the euro area remain on the downside” and that the “staff projections are conditional on the full implementation of all our policy measures”.

Hence, even though the German bonds and the EUR had a bullish knee-jerk reaction to the upgrade in growth forecast, they reversed their gains as soon as markets grasped that they rely on the assumption that QE will help growth and that lower oil price will feed into consumption. In the same vein acted the realization that the upcoming liquidity injection (EUR60 billion per month) is at the moment a stronger market driver as it is scheduled to start on 9Th March.

As a result, the European Government bonds gained while the EURUSD fell towards 1.1 level. The peripheral bonds also had a positive day, with Greece joining the rally after the ECB decided to increase the emergency landing available to Greek banks; meanwhile, the Greek government bonds will not be included in ECB’s bond purchasing programme as compliance with the bailout conditions is a conditionality. The positive momentum spread to more risky assets with EuroStoxx50 gaining 1% and the high yield bonds seeing fairly good demand.

As sceptical as some might be when seeing the 10 year yields for Italy and Spain below 1.5% and the one for Portuguese notes at less than 2%, the reality is that at the moment these are due to be driven by the unleash of liquidity more than anything else. That is, in this ultra-low-yield environment their yield pickup relative to core European countries becomes the main focus for investors. Indeed, a survey conducted by RBS showed that 70% of the respondents are buying/holding such assets and that only 26% of those surveyed would be willing to sell their holdings of non-core bonds to ECB; 47% would be willing to sell “only at much lower yields”.

In the US on the other hand, the markets had to contend again with below expectations statistics as the weekly unemployment claims were higher than anticipated whereas the factory orders fell although the consensus was anticipating a 0.2% monthly gain. Hence, the Citi Economic surprise index, which basically is built based on the difference between the actual figures and the estimated ones for a wide range of indicators, dipped further into negative territory.

The fact that the momentum in the US is failing to meet expectations is yet another sign that yields worldwide might be low for longer. China’s 7% growth target announced yesterday speaks of a similar scenario as a slowing Chinese economy puts downward pressure on commodities, which in turn alleviates the already anaemic inflationary pressures. The announcement comes after just last week the Chinese Central Bank cut its lending rate to 5.35%, the second such change in three months; to appreciate the significance of this monetary policy decision, I think it is enough to say that the previous change in rates was in June 2012.

What is more, the struggle of the Chinese authorities in restoring higher growth rates might prompt a depreciation of the Chinese yuan which would mean that the goods imported from China by US or Europe will cost less. We would thus have another downward pressure for prices and yet another motive for buying bonds; with the QE poised to start on Monday, we seem to have a strong case for investing in such assets.

Subdued growth and low inflation should in my opinion be supportive for risky assets provided that central banks are successful in managing expectations and avoiding a collapse in sentiment. Whatever the case, in the following weeks I see limited scope for fatigue in the markets particularly as the economic data has surprised on the upside in Europe and the ECB’s QE announcement came after a weak year-end. What is more, Draghi’s discourse succeeded for now in lifting inflation expectations as the long term market gauge is now at 1.76%, the highest level in three months.

Have a nice day!

Raluca