Tapering needn't cause a tantrum. As expected, last week the European Central Bank (ECB) announced a further reduction in the pace of its monthly bond purchases to EUR 30bn from EUR 60bn and extended the program by nine months.
Markets absorbed the well-flagged news, helped by the ECB’s dovish reassurances accompanying the hawkish announcement. Immediately after the news, the Euro Stoxx 600 extended gains made prior to the meeting to rise 0.8%, while the euro fell 0.5% versus the US dollar.
The sanguine market reaction is a far cry from the sharp sell-off in bonds and equities that followed the Federal Reserve's (Fed) May 2013 statement that it was thinking about tapering. Investors – and central bankers – have since learned that withdrawing monetary accommodation need not mean the rally in risk assets is over. For example, the total return on the S&P 500 has increased by 57% since
the Fed announced on 18 December 2013 it would start tapering its bond purchases. Our takeaway from the ECB decision is clear: don't panic, and stay invested in equities.
Of course, the ECB's latest step to monetary tightening is likely to change some market dynamics, creating opportunities:
- European junk bonds look vulnerable. Driven by strong demand, low issuance, and improving credit quality, the BAML Euro High Yield Index's effective yield hit a record low of 2.15% this month and currently stands at 2.17%. (Effective yield takes account of issuers' ability to redeem the bonds before maturity). This is virtually the same yield as similar duration US five-year Treasuries (2.07%). The spread between European high yield and German Bunds, at 233bps, is also the lowest in the post-financial crisis period. While the healthy European growth outlook and corporate fundamentals suggest no cause for alarm, we think Euro high yield bonds are expensive. Once underway, we believe ECB tapering
should have an impact, triggering spread widening and greater volatility in high yield.
- The SEK should outperform the CHF. ECB tapering is the latest monetary domino to fall. Each central bank step to withdraw stimulus makes it easier for its peers to follow. Sweden's inflation and growth outlook suggest the Riksbank is likely to raise rates again soon. In contrast, we expect the SNB, which has said the CHF is "highly valued" versus the EUR, to be slower to tighten policy. (Although a move above the old floor in EURCHF of 1.20 might prompt a change of heart).
- Near term, the euro may weaken against the dollar. The ECB expressed concern at the euro's rapid appreciation earlier this year and Draghi's dovish comments after the meeting are likely aimed at the currency – including his remark that an "ample" amount of stimulus remained necessary and that maturing debt would continue to be reinvested for "an extended period of time." On the other side, the dollar could be supported by progress on tax reform and the potential for a more hawkish Fed chair.
So we remain overweight global equities and underweight European high yield bonds. We are also overweight SEK versus CHF and, over the coming three months, we expect EURUSD may fall towards the low end of a 1.15-1.20 range.
Global Chief Investment Officer WM
The ECB safely negotiated the announcement of a further reduction and extension of its bond buying program without unsettling markets. Investors need not panic and should stay invested in equities. ECB tapering will also create opportunities; we believe European high yield bonds are expensive and look vulnerable, that the SEK should outperform the CHF, and the EUR may weaken near term versus the USD.
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