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Important Period For Central Bank Policy

5 June 2017 by Mark Holman

Over the next 10 days we will have important policy decisions from some of the key central banks.

Starting tomorrow with the Reserve Bank of Australia (RBA), then Thursday from the ECB, and next week we have the FOMC on Wednesday and the MPC here in the UK on Thursday.

Whilst the MPC and RBA are likely to have no change, we will be watching very closely what is said by the FOMC and the ECB in their respective prepared remarks and press conferences.

So what do we expect?

Starting in Europe, there is little doubt that the European recovery has gained momentum, and Europe has certainly benefitted from the coordinated global recovery taking place. A number of ECB watchers are already speculating as to when the first hike will be, and how and when the current QE programmes will end.

In terms of any action in this regard, we think this coming meeting is still far too soon. What we can look for though is a change in the outlook for growth where we expect Mr. Draghi to finally remove the comment that the risks to economic growth are tilted to the downside, replacing it with language saying that they are balanced. We think this is warranted and therefore quite likely.

He may also go on to qualify his forward guidance “The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases” by removing “or lower levels”. This is probably also warranted but Mr. Draghi is a master tactician, and he may hold off on this until the September meeting.

At the September meeting we also expect him to once again reduce the amount of monthly purchases by another €20bn per month, taking the QE programmes to just €40bn per month from December onwards. Not until the QE programme has no net new purchases is there a chance that he will hike the Deposit Rate, which even with supporting economic growth should be at least a year away.

The effect of this on Eurozone government markets should be a steepening of the yield curve, hence we see no value in 10 year Bunds at 0.27% currently.

Moving over the pond to the US, we fully expect another 25bps hike by the FOMC, taking the upper boundary of the Fed Funds Rate to 1.25%. This is currently 90% priced into the market, but what happens after this latest hike is probably more open to interpretation. Growth so far this year has been a little disappointing and the inflation outlook is certainly more subdued than it was back in February, when markets were expecting big infrastructure projects and large tax cuts from the new administration. Friday’s employment report only served to add more to the uncertainty. Despite being close to full employment, wage growth and inflation seem firmly under control at the moment, so will the FOMC pause after this next hike to monitor the effects of 3 hikes in 6 months?

We already know that some form of balance sheet reduction will happen this year and that it will be a gradual retracement of reinvesting coupons and maturities.

We think this presents the FOMC with a perfect opportunity to carry on with its “normalisation” of policy, while also adopting a wait and see approach to incoming data. Consequently, in the absence of stronger data, we expect a hike next week and then a pause from hiking until December, with the September meeting being used to reduce balance sheet.

As we mentioned in last week’s blog, this scenario probably means that we have seen the high point in UST yields already for 2017 when they hit 2.63% in March. However, at 2.16% where they are now, it is still hard to justify a long position.

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