ECB decision likely to stoke inflation expectations

Paul Shanta, co-manager, Old Mutual Absolute Return Government Bond Fund, Old Mutual Global Investors

Today the European Central Bank (ECB) delivered its last monetary decision of the year for the euro area. 2016 has been an increasingly turbulent year for the global economy, with the UK’s decision to exit the European Union and Donald Trump winning the US presidential election. With last weekend’s Italian referendum delivering the expected, but again disruptive, “no” vote and Matteo Renzi resigning as prime minister on the back of that result, the world – and in particular, the euro area – doesn’t look like it’s heading to calmer waters in 2017.

With such a backdrop, it is not a surprise to us that the ECB and Mario Draghi, its president, have extended their bond-buying programme today. Although it has announced that it will reduce the purchases down to €60bn a month from April next year until at least December 2017, Mario Draghi also stated that “reducing purchases to zero hasn’t been on the table”, making a sharp contrast to the reduction of buying engaged by the US Federal Reserve in 2013. Core inflation is still running someway below the ECB’s target and while headline inflation may well pick up over the course of next year, there appear to be few signs of any lasting inflationary pressures in the Eurozone. While European unemployment continues to fall, there is still a huge amount of spare capacity in mainland European economies and unlike the US and UK, there appears to be little flexibility over the potential for fiscal stimulus.

The ECB’s bond-buying programme has resulted in well-documented effect of shortages in bond collateral in parts of the fixed income market; this will plainly not be alleviated by today’s decision. European government bond collateral is likely to continue to trade more expensively against swaps as this policy extends, and given the increasing divergence of economic fortunes and policy in the US and Europe, US yields are likely to continue widening versus those in ‘core’ Europe. The move should again dampen the volatility of rates both in the eurozone and globally, as well as provide further support to asset prices. We expect to see a re-pricing higher in European inflation expectations as Draghi has again proved he is willing to ignore his critics and push on, doing what it takes to stabilise the euro area. With inflation expectations rising, we should see a continuation of the fall in the euro in the very short term.