Emptying, not removing the punchbowl

Deeper dive

Last week the European Central Bank (ECB) announced that it will end its quantitative easing (QE) program by the end of the year, and the Federal Reserve (Fed) raised interest rates by a further 25 basis points. After leaving policy unchanged, the Bank of Japan (BoJ) is now the only major central bank yet to announce an end to QE.

In the wake of these decisions, US 10-year Treasury and German 10-year Bund yields declined, Eurozone and US equities rallied and the euro suffered its largest one-day drop since the Brexit vote in June 2016.

Looking at the Fed and ECB’s decisions in more detail, the shortterm reaction makes sense. ECB President Mario Draghi seems to have accomplished the difficult task of announcing an end to QE without sparking a 2013-style taper tantrum. Central banks are signaling that they won’t keep filling the punchbowl, but they’re not taking it away completely.

  • An end to the ECB’s bond purchase program this year was expected, but is now data dependent. The central bank’s commitment not to raise rates until “at least the end of summer 2019” was unexpected. Draghi also highlighted the risks to the economic outlook, such as rising protectionism, and cautioned that the recent soft patch in Eurozone data may last for longer. 
  • The Fed’s rate hike was widely anticipated too, reducing its market impact. The Fed acknowledged the US economy’s strength by increasing its growth forecast for this year from 2.7% to 2.8% and lowering its unemployment forecast from 3.8% to 3.6%. But there was no indication that this will prompt faster tightening, and the Fed has already said it will look through a temporary overshoot of its 2% inflation target. The median projection for rate hikes this year increased from three to four, but this reflects an increase in just one official’s forecast, and we also view it as a mark-tomarket that matches our forecasts.

Looking beyond the immediate reaction, over the medium term what are the likely implications for investors?

The data dependent winding down of ECB QE and the gradual pace of Fed tightening are unlikely to unsettle markets. Meanwhile, the global fundamental backdrop remains positive, with strong economic and earnings growth. As a result, we expect global equities to continue grinding higher.

The turning point in ECB policy is likely to promote higher Eurozone government bond yields over time and should lead to a modest narrowing in the yield gap with the US. This is likely, ultimately, to support the euro, which remains undervalued versus the US dollar, with a purchasing power parity of EURUSD 1.29 versus 1.16 at present. The end of ECB QE is one of the necessary conditions for a sustained euro rally, but this will also require further evidence that the soft patch in Eurozone growth is over, that political risks in Italy have abated, and that US 10year Treasury yields will not rise much further. We are currently neutral on EURUSD in our Tactical Asset Allocation.

The end of corporate bond purchases by the ECB, which have been running at EUR 5bn per month recently, removes an important support for European credit markets. As the global economic cycle matures, we recommend that investors reconsider credit exposure if it is above their strategic benchmarks.

Mark Haefele 

Global Chief Investment Officer GWM

Bottom line

Last week – as widely anticipated – the Fed raised rates, the ECB announced the end of crisis-era QE, and the BoJ left policy unchanged. Markets reacted in a risk-on way and the euro fell, as the ECB pledged to keep rates on hold for longer than expected and the Fed took stronger US economic conditions in its stride. Over the medium-term, we expect global equities to grind higher, Eurozone sovereign yields to rise, and the euro to recover.