The ECB is expected to end net QE, albeit maintaining a dovish bias due to slowing growth and elevated financial asset volatility
The ECB is expected to announce the end of its net asset purchases (current pace of €15bn per month) at its meeting on 13th December 2018. The end of net QE will gradually begin to put upward pressure on Bond yields.
The ECB has accumulated circa €2.1tn in sovereign bonds since March 2015 (30% of euro area marketable debt), and we expect it to roll-over the full amount of maturing bonds de minimis for two years. Consensus forecasts of 0.89% by end-2019 for 10-Year German Government Bonds (forwards: 0.39%) appear well-founded, particularly when the net government bond issuance of the largest euro area members is expected to pick up slightly in 2019 to circa €205bn (see graph).
The ECB will likely maintain its forward guidance that interest rates will remain at current levels (0% and -0.4%) at least through the summer of 2019. We expect an update of the interest rate forward guidance up to April 2019. Based on our EONIA forward curve estimation, markets expect the first 15 bps hike in Q1:2020, pricing-in a cumulative hiking path of circa 60 bps by end-2021 (see graph).
We view current market pricing as impracticable over the forecasted horizon (2021). On the one hand, assuming GDP growth converges gradually to potential rate of output (circa +1% to +1.5% from above now) and core CPI increases towards +1.5% as wage pressures begin -- a scenario consistent with ECB forecasts -- the ECB could proceed faster than current market pricing. On the other hand, a lower likelihood scenario involves the ECB remaining unchanged due to a weaker-than-expected domestic economic performance and a more-aggressive-than-expected slowdown in US and China GDP.
Risk appetite was tempered in the past week. The brief inversion of the 5/2 part of the US Treasury curve (the 10/2 term spread bull-flattened by 7 bps wow to 14 bps reaching 12 bps intra-week -- the lowest since June 2007) intensified the sell-off, reflecting market expectations that the Fed will respond (pause) to the likelihood or inception of a US recession. Concerns regarding US economic growth prevailed sending global equities down by -3.5% wow and -7.6% ytd (MSCI ACW Index). USD High yield corporate bond spreads widened by 21 bps to 450 bps, their highest level since December 2016 (see Markets -- page 3).
However, US economic data over the past week did not increase the likelihood of a US recession during the next twelve months (NFPs were strong at 155k – see Economics). Trade détente doubts (exaggerated by the arrest of Huawei CFO), the delay of the Brexit Agreement vote and OPEC’s fault lines regarding oil supply policy weighed on sentiment.
Overall, economic growth is expected to decelerate in 2019, albeit the pace of deceleration will set investors’ tolerance towards risk. The ongoing reduction of central banks’ liquidity (Quantitative Tightening) adds volatility. Our Tactical Asset Allocations end the year with Global Equities slightly below our Strategic Asset Allocations and Cash overweight. Our Global Government Bond underweight position was hit hard during the past week (as yields declined significantly), albeit remains in positive territory ytd.