3 Things the European Investment Grade Fixed Income Team Talked About Last Week

Cork, Ireland

1. Euro-area Inflation: Frankfurt – We Have A Problem

We mentioned in last week’s blog about the likelihood that Euro-area inflation would show a significant increase when the January numbers were released. We began to get an indication that the number might be quite strong when Spain’s inflation number topped 3%, but even we were surprised when the number printed at 1.8%, well above market expectations of 1.5% and the previous December number of 1.1%. In fairness, the core number remained unchanged at 0.9%, but that won’t be much comfort to the German press nor the Bundesbank, who saw headline German inflation rise to 1.9%. This will increase the pressure on the ECB and ECB President Mario Draghi to consider their monetary policy stance, especially in light of the strong Q4 2016 GDP number of 0.5% quarter-on-quarter, and the strong start to 2017 as evidenced by the recent Purchasing Managers’ Index (PMI) numbers. Perhaps it was in anticipation of this problem that Mr Draghi noted there were four conditions the ECB would need to see before being convinced that a sustained inflation adjustment had occurred:

  1. Inflation converging to the ECB’s medium-term target of “close to, but below 2%
  2. Convergence must be sustainable
  3. Convergence must be sustained without monetary policy support
  4. Convergence must be across the whole of the eurozone

In reality, we are still some distance from those four conditions being met, and we expect that the inflation numbers will peak in April before falling back towards the 1.5% level. Inflation breakevens have risen quite a bit recently, and that is largely what has driven nominal bond yields higher. Real yields haven’t really moved much, and remain at historically low levels. We believe this could drive the next leg higher in nominal bond yields – an increase in real yields. We think being short real yields in Europe is the most attractive way to position for higher inflation in Europe over the coming months.

2. Currencies: Whisper it, But Trump Might Be Right

For much of the recent past, the FX market has operated under the assumption that the U.S. administration was in favour of a strong U.S. Dollar policy. This goes back nearly two decades to the Clinton government, when U.S. Treasury Secretary Robert Rubin was noted for endorsing a strong U.S. Dollar at almost every opportunity. And even though at times, this policy caused some headaches, each administration since Clinton has re-affirmed this commitment, at least verbally. Neither has any recent President commented specifically on the levels of the U.S. Dollar, so all the more surprising, that U.S. President Trump recently stated that the U.S. Dollar was “already too strong”. He accused China and Japan of “playing the money market, they play the devaluation market, while we sit here like a bunch of dummies”. And just in case the markets didn’t get the message, Peter Navarro (Head of the U.S. National Trade Council) followed up by accusing Germany of having a “grossly undervalued exchange rate”. Despite all the head shaking and tut-tutting about Trump and Navarro’s comments, there may be a grain of truth in what they say, particularly with respect to Germany. It is widely acknowledged that Germany managed to lock in a very favourable (some might say undervalued) exchange rate at the start of the Euro, which its economy (mainly export-orientated) has benefitted from over the past two decades. The corollary to that is other countries in the eurozone (most notably Italy) entered the Euro at quite an uncompetitive exchange rate, and that has led to competitiveness problems for those economies. But we believe the real problem lies with Germany’s inability (or unwillingness) to reduce its massive current account surplus – currently close to 9% of GDP. In a system with fixed exchange rates, there should either be a method for internal fiscal transfers or a recycling of current account surpluses, otherwise the poorer or less-competitive countries will continue to struggle. If neither happens, the Euro area and the Euro currency could continuously face concerns about its future viability.

3. UK: The Calm Before The Storm?

Last Thursday saw what is now commonly referred to as “Super Thursday” – the day upon which the Bank of England’s (BoE) quarterly Inflation report is released, the day the Monetary Policy Committee (MPC) meet and the day the minutes of the previous MPC meeting are released. The message from last week was one of “business as usual” – the MPC voted unanimously to keep all monetary policy settings unchanged, but the BoE did make a surprisingly large upward adjustment to their GDP forecast for 2017 from 1.4% to 2%. At the same time, the BoE also revised down their estimate of the UK’s neutral unemployment rate from 5% to 4.5%, indicting a higher degree of spare capacity in the economy than previously thought. The stronger growth forecast but greater spare capacity forecast allowed the BoE to effectively leave their inflation forecasts pretty much unchanged over the forecast period. Despite markets having moved in recent weeks to price in a rate hike by early 2018, the MPC were at pains to point out that policy could move in either direction. The reality, however, is that a move in any direction remains unlikely. But the minutes of the previous meeting did point to some potential disagreements between MPC members, and noted a wide variety of views. According to the minutes “for some members, the risks…meant they had moved a little closer to the limits” to which they would tolerate inflation running above target. Despite the BoE’s upward adjustment to their 2017 GDP forecast, we continue to worry about a potential fall in economic activity once Brexit negotiations begin in earnest later this year, and remain underweight UK Gilts.