3 to 9 October: Yield to Pressure

Government bond yields pushed higher last week as investors were given a plethora of reasons to question the “no growth, no inflation, QE forever” dogma.

First, a Bloomberg article suggested the ECB could announce a tapering of its monthly asset purchases (currently EUR 80bn), following the expiry of the current programme in March 2017. Taken in the context of Japan’s recent decision to start tailoring purchases to manage the shape and level of the yield curve, this rumour solidified concerns that the cost/benefit of central bank asset purchases might be shifting against further stimulus. In particular, the sheer size of quantitative easing has turned government bonds into a policy instrument (rather than an investment asset) and is putting very obvious pressure on bank profitability.

The ECB has quickly denied the report and our base case remains that QE will be extended for at least a further 6 month period (to September 2017).This is not to say we think it is an effective policy. Rather we cannot see the economy sufficiently strong for the ECB to reduce stimulus and believe the fragmented, 19 state currency union will only ever be a follower on policy innovation. With respect to the next steps for developed market monetary easing, we reiterate our belief that we are reaching its upper limits. Ultimately, money is a medium of exchange and going deeper into negative interest rate territory, or embarking on helicopter money, has to challenge credibility. Related, we expect whatever form monetary policy takes going forward, it is likely to be less favourable for bond markets.

Elsewhere, tough talking by cabinet members markedly shifted the market’s pricing of a “hard Brexit” in which the UK’s stance on immigration and political sovereignty will be inconsistent with access to the single market. This resulted in a sharp repricing of GBP (including a Friday flash-crash) and a sell-off in Gilts, as currency depreciation shifted long-term inflation expectations (measured by the 5 year-5-year forward) to as high as 3.62%. Last, on Friday, the US employment report showed enough resilience to support a December rate hike from the FED (probability up to 65%). This saw the US 10 year briefly test June highs in yield. Indeed, this followed a positive tone to global data for the week.

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