One of the useful adages for any investor is ‘follow the money’. This was a week when a large amount of capital might have decided to leave the UK, spurred on by news of a final breakdown of the interminable and torturous negotiations between the UK and the EU. However, the currency markets continue to be the canary in the coal mine for the process that is Brexit. The euro-sterling exchange rate has waxed and waned but remains in the broad trading range seen since the late spring. Investors are still waiting to see whether Sunday’s talks mark the end of the beginning or the beginning of the end.
The most important central bank meeting this week was in Europe. The news that the ECB will try to be even more supportive for the European economy comes as little surprise – it had been dropping broad hints since October. The package consists of an expansion in the emergency bond buying programme of about a third, alongside a new parcel of extremely cheap loans for banks. In particular, the length of time which this programme will run has been extended. Net purchases will last at least until March 2022, reinvestments of principal payments will run at least until the end of 2023, while the funding-for-lending scheme will be extended by 12 months until June 2022. Any other statements from the ECB about bolstering inflation should, of course, be taken with a large pinch of salt, while its updated growth forecasts very much follow the lines of the IMF and OECD – and will be vaccine dependent.
The favourable effects of the ECB’s actions have been seen and should continue to be seen in the European bond markets. Yields in the so-called ‘peripheral’ nations, Italy, Portugal and Spain, are at all-time lows. Indeed, Spain has been able to issue 10-year bonds with a negative yield for the first time ever.
It is another matter entirely whether the ECB’s actions will have much of an effect on the real economy in the near future. Ski resorts, restaurants, theatres, these will not re-open simply because of cheaper money. Government diktat and consumer uncertainty, even fear, are rather more important factors. Nevertheless, the ECB’s actions are helpful indirectly – the sizeable amount of fiscal support in many European countries (such as the €750 billion EU programme), and the large amount of corporate debt and in some cases household borrowing, all remain very easy to service. In brief, the ECB is the backstop for the bond market.
One drawback from the ECB’s actions, however, is the lack of trading liquidity which is appearing in that market. A similar phenomenon has been seen in Japan. Bloomberg has forecast that the ECB is on course to own about 40% of German and Italian bonds by the end of next year. Many other bond investors are ‘buy and hold’, for example insurance companies. Hence the active trading in European debt is falling away. Axa reported that trading volumes in German bund futures have declined by about 60% since the ECB began its buying programme. In brief, price discovery is rather difficult when a central bank dominates the market place.
The UK gilt market continues to be well bid against this backdrop. The 10-year bond yield has declined from about 0.35% to about 0.22% during the course of December. Of course, as well as the news about Brexit or the ECB statement, there has been growing evidence that the UK economy will experience a very weak 4th quarter, while the CBI was the latest in the long line of forecasters warning that the pace of the recovery will still mean extensive unemployment and a large amount of spare capacity in many industries. However, the various vaccination announcements are the rays of sunshine on the dark horizon. The current level of benchmark yields remains well below the troughs of closer to 0.1% in the spring or 0.15% in the summer. From the point of view of a technical analysis, these would remain firm floors to the current downward trend.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making