BNY Capital Market Perspectives

Lest We Forget – Central Banks in the Spotlight

While political developments have been the biggest market drivers over the past month, lest we forget, the central banks remain the largest holders in the debt market and therefore the largest arbiters of valuation. The market’s focus will therefore pivot, at least temporarily, from the political landscape towards the next steps for monetary policy. While the Fed’s fate on a December rate hike is likely sealed, other central banks may still hold surprises. These results will be revealed over the course of the next few weeks as the biggest central bankers are set to hold their last meetings of the year. The ECB kicks off the holiday party with the meeting of the Governing Council tomorrow, which is widely expected to include an extension of the current QE buying program. Such an extension has been expected for the past several months, but Mario Draghi has been coy in signaling his intentions on its bond buying program, which presently purchases 80 billion euro per month and is set to expire in March 2017. Structurally, the program is running up against buying limitations as various rules maintain that the proportion of an individual sovereign’s bond purchases largely equates to the size of that country’s economy within the EU; a restriction known as the capital key. When the capital key is combined with other rules, such as the deposit floor, which limits purchases to securities that yield more than the depo-rate established by the ECB, the universe of eligible bonds becomes scarcer, especially for Bunds, which maintain the lowest yields in the EZ while simultaneously having the largest capital key. Therefore, while investors are largely expecting an extension of the bond buying program, possibly into fall 2017, we also think that the ECB has to acknowledge improvements in the inflation profile, which recently moved upwards to 0.6%, still well below its 2% target, but also at a two year high. Economic data has also generally exceeded expectations since the start of the year, with the EZ economic surprise index near a three year high. Therefore, while global yields are slightly lower today, apparently in anticipation of changes from the ECB, we don’t anticipate them to be exceedingly and surprisingly dovish and continue to see higher yields as the path of least resistance.

Continue reading »