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Unintended Tightening

22 November 2016 by Mark Holman

Since the end of September we have seen yields in European rates markets move steadily higher, initially driven by loose talk of tapering by the ECB, then intensified by contagion from the US election outcome and the almost certainty of a US rate hike in December. For those who like to follow what futures markets are predicting, we are now pricing in a 100% probability of a hike on December 14th.

While this move wider in European rates has been happening we have also seen a reversal of the compression trade that Draghi has been targeting. While the periphery generally tends to have higher beta to these upward moves, in this instance we are further driven by the Italian constitutional referendum on December 4th. Rather than being a referendum on constitutional reforms, this is now more about the individual personality contest of Renzi vs Grillo, and as we go into the polling blackout it looks like Renzi is set to lose as the protest vote remarkably goes to the candidate who does not want change!

Anyway, enough of politics, the upshot is that since September 28th  the 10 year Bund is 40bp higher, the Italian BTP is 76bp higher and the Spanish Bono is 60bp higher. Essentially a rate hike for all of Europe, and a return of fragmentation across the Eurozone, both of which fly directly in the face of ECB policy.

The next ECB Governing Council meeting is on the 8th December. We had expressed caution that at some stage the ECB would have to taper, and although we did not expect them to announce it in December we felt that Draghi would have to begin getting his message across that at some point the ECB would no longer need to buy €80 billion per month to have the same effect, particularly as they now hold such a large amount of the Eurozone’s risk-free assets.

Having seen this back up in rates though, especially for the periphery, we no longer think this is the time for lectures about tapering, and Draghi should use the press conference to reinforce the current policy by announcing another six month extension to the programme to the end of September at least, which would be an uplift of €480bn to their balance sheet.

The whole concept of tapering does make us nervous though, and we know at some point it definitely will happen. In fact yesterday ECB Executive Board member Coeure acknowledged that point saying “at some point we will start scaling down. Not yet”.  For now though, unintended tightening trumps tapering. From a risk perspective this does not mean jumping back into European sovereigns just yet, with politics trumping QE as we head into the crucial vote in Italy.

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