The minutes of the FOMC´s March meeting were more dovish than expected. They underlined that the Fed considers that US policy rate hikes are still some way off. This weighed on the dollar, and hence pushed up the EUR/USD, which triggered a reaction from ECB President Draghi over the weekend, who warned that a strengthening of the exchange rate would trigger further monetary stimulus. Some combination of low inflation outcomes and a firm euro could trigger further easing. In this case, a rate cut would be the most likely first response, which could include taking the deposit rate into modest negative territory. Meanwhile, we have adjusted our 3m forecasts for government bond yields downwards, but have kept our year-end projections unchanged.
Fed´s March minutes strike an unexpectedly dovish tone
The minutes of the FOMC´s March meeting were somewhat more dovish than expected. For a start, there was no evidence of an explicit discussion that policy rates could be raised six months after the ending of the Fed´s QE-programmes, something that was suggested by Chair Yellen in the press conference after the meeting. Although we do not know whether or how many FOMC members would support such a move, we continue to think that Ms. Yellen´s remark was no slip of the tongue. Meanwhile, the minutes showed that the FOMC met by videoconference to discuss the consequences of removing the 6.5% threshold. This was done because market expectations of the future course of monetary policy were seen as being ´reasonably well aligned´ with those of the Fed, and members were afraid that a change to a more qualitative forward guidance could ´disturb this alignment´. Again, the caution surrounding the scrapping of the 6.5% threshold suggests that FOMC members had no plans to signal to markets that earlier-than-expected rate hikes was something that could be on the table.
We expect policy rate hikes in mid-2015
Meanwhile, FOMC members also feared that the upward shift in participants´ projections of the federal funds rate in comparison to December´s Summary of Economic Projections could be misread as indicating a move by the Committee to a less accommodative reaction function. But ´several participants´ noted that the increase in the median projection ´overstated the shift in the projections´. Finally, concerns about the low level of inflation shined through the minutes. For example, five participants saw the risks to their inflation forecasts as tilted to the downside, while members generally agreed that ´in light of their concerns about the possible persistence of low inflation´, ´inflation developments should be monitored carefully for evidence that inflation was moving back toward the Committee´s longer-run objective´. We continue to think that the strength of the recovery in the economy and labour market will surprise the FOMC on the upside. Together with relatively moderate growth in labour supply, we judge that the unemployment rate is set to fall faster than the Fed currently projects. The sharp fall in initial jobless claims this week to a 7-year low supports this view. Overall, we expect the Fed to start raising rates at the middle of next year, with the federal funds rate rising to 1.5% at the end of 2015.
Draghi steps up verbal intervention on euro
ECB President Mario Draghi stepped up the central bank’s verbal efforts to stem euro strength over the weekend. Speaking to reporters following the IMF meetings in Washington he said that ‘the strengthening of the exchange rate would require, to make our monetary policy stance equally accommodative, further monetary policy accommodation’. Mr Draghi appears to be trying to head off the latest bout of euro strength that was triggered by the more dovish FOMC minutes last week. It is not clear exactly where the trigger point would be for the ECB in terms of further euro strength. Given the sensitivity of inflation to exchange rate movements, we calculate that a EUR/USD rate of 1.42 or above could trigger further monetary easing. However, it could be that the euro would not need to go quite so high if inflation rates continue to undershoot the ECB’s forecasts in coming months. So some combination of low inflation outcomes and a firm euro could combine to trigger further easing. In this case, a rate cut would be the most likely first response, which could include taking the deposit rate into modest negative territory. Separately, we judge that a small asset purchase programme – based on ABS – is a distinct possibility. On the other hand, large scale QE still does not seem very likely despite recent speculation.
Government bonds remain supported
US Treasury yields and German Bund yields have fallen further over the last few days. This reflects expectations of a more accommodative monetary stance than previously. In the case of the Federal Reserve, this means later rate hikes. In the case of the ECB, this equates to additional near term monetary easing, with the prospect of a large scale QE programme having caught investors’ imaginations. In addition, a tech-led sell-off in equity markets has led to some safe haven demand for government bonds. Given the continued drift lower in yields over the last few weeks and the more dovish tone by central bankers we have lowered our 3m forecasts for 10y Treasury and Bund yields. Treasury yields are still expected to rise (though more modestly) as the US economy is expected to strengthen noticeably as it shakes off the effects of the bad weather. Bund yields are likely to remain better anchored by low inflation and ECB easing speculation. We have kept our year-end forecasts unchanged. We hold on to the view that global economic growth will strengthen more noticeably and disinflation will end. In addition, Fed rate hike expectation should start to build toward the end of the year, while the ECB will likely refrain from large-scale QE.
Greece makes spectacular return to the bond markets…
Finally, in a milestone for Europe’s sovereign debt crisis, Greece returned to the bond market last week for the first time since it was bailed out in 2010. The government sold 5y bonds and raised EUR 3bn, following more than EUR 20bn in orders. More than 90 per cent of the bonds issued went to foreign investors. Investor appetite for peripheral bonds has strengthened noticeably on the back of easing concerns about a euro break-up, helped by the ECB’s OMT programme and the clear commitment of European governments to the single currency area. In addition, fundamentals in peripheral countries are improving and economic growth is returning. At the same time, more positive risk sentiment and the low rate environment has encouraged a search for yield. Finally, speculation about a large scale ECB QE programme has also driven spread compression over recent weeks.
…but debt sustainability not yet resolved
We are positive on Greece’s economic outlook, but we continue to think that it has a debt sustainability problem that is not yet clearly resolved. On the positive side, Greece’s competitiveness in terms of relative unit labour costs has improved sharply and is now close to the levels seen at the start of the euro era. Economic growth is also now returning, and we thing that the Greek economy could be one of the positive surprises of 2015 (with growth of around 3%). However, government debt is in excess of 170% GDP and some kind of ‘solution’ is necessary, which will likely involve restructuring of official sector/bilateral loans. Until a clear plan is in place to restore Greece’s debt sustainability, this will remain a cloud on the horizon.