The ECB delivered on its promise of action at this week’s meeting and, if anything, slightly exceeded expectations with such a clear “we are not finished” statement. Equity and bond markets rallied strongly and there is a feeling among some analysts that there could be a summer “melt up” in equities. Although our work has indicated for some time that, for the long-term, equities are expensive and bonds offer little value, the market action was extremely strong post the ECB meeting. Our tactical view is that there is no point standing in front of this particular runaway train and therefore we are mostly long European equities and bonds. With such financial repression from the ECB, investors will feel impelled to chase yield further.
Our main conclusion from the ECB is that the new round of stimulus is as much about trying to weaken the currency (a 10% move in the Euro impacts inflation by 0.5%) as it is about trying to increase lending to the real economy. We have discussed the FX markets a lot in recent weeks and so will not repeat ourselves again today. Suffice to say, the fact that the ECB delivered on its promise for action and remains willing to do whatever it takes, should be a headwind for the Euro over time.
Of course, other factors influence currency rates and with two and with five year yields across Europe (except Portugal and Greece) below those available in both the US and UK, there should be less of a desire for non EU investors to pile capital into Europe’s bond markets which appears to have been a significant cause of strength in the Euro last year.
In the US and UK, as apposed to Europe, talk is increasingly of rate rises at some point next year. Furthermore, the short squeeze in bonds in April and May appears to be over and we now expect the whole curve in both the US and UK to shift higher which should be supportive of the Dollar and Sterling over time. The US employment report at the end of last week continues to indicate an economy capable of about 3% real growth (see chart below) and it is simply not prudent to expect yields to remain near 2.5% in that environment.
Bond yields should track nominal rather than real growth and we suspect that the US economy can generate growth somewhere in the 5% range in the next few quarters (3% real plus 2% inflation). In this environment, the FOMC has no choice but to end QE (probably in October) and lay out their plan to raise interest rates in 2015. As shown in the chart below, whenever 10 year bond yields (in red) remain below nominal GDP for too long (late 1990’s and in the years before the financial crisis) trouble is usually not too far away in the form of rising rates. Either bond yields rise or nominal GDP needs to fall in the months ahead. Either scenario would see an increase in volatility which, as we have shown in recent weeks, is close to all time lows and also associated with troubled times ahead.
So our message this week is that the ECB is desperately trying to weaken the Euro and a side effect of that is likely to be higher EU equity and bond markets (at a minimum we should expect them to outperform the US). At the same time, the US economy is doing just fine and both short end and long end yields are rising again. In fact, given the growth in the US, yields should be much higher (or growth much lower). Markets are rejoicing the moderate growth/high liquidity environment we have discussed before and volatility has collapsed further as a result. We continue to believe that the environment has to change at some point and if yields rise or growth falters, volatility should rise and risk assets will be vulnerable. In all of this, we see a strong US Dollar especially against the Japanese Yen and Euro where the central banks are doing whatever it takes.