Quick View: Excessive Optimism in Europe?
Having steered clear of immediate policy issues at the Jackson Hole symposium in August, the European Central Bank president, Mario Draghi, provided no fresh clues at the central bank’s latest meeting held on Thursday, September 7. Janus Henderson’s Mitul Patel, Head of Interest Rates, shares his views on the next steps for the central bank and the market’s expectations of policy direction in Europe.
As expected the European Central Bank (ECB) gave no indication of its plans for asset purchases next year. The central bank’s latest forecasts showed smaller than expected revisions to its inflation projections in 2018 (1.3%) and 2019 (1.5%) and, while gross domestic product (GDP) growth was upgraded to 2.2% for this year, forecasts for 2018-19 were left unchanged.
The market was looking to see if the ECB showed any concerns about the strength of the euro; and, although Draghi talked about the need to monitor the impact of euro strength on medium‑term inflation, there seemed little desire to push back against it more aggressively.
Our expectation remains that the ECB will announce further asset purchases next year, with the pace dropping to €40bn per month for the next six months. There seems little that the ECB can do to lean against currency strength, with a reduction in purchases inevitable given the constraints on the existing purchase program. Although some expect a reinforcement of forward guidance as the primary tool to contain currency strength, with so few interest rate hikes expected or priced in over the coming years, this is unlikely, in our view, to be effective.
Further, while a rally in the euro is somewhat justified given the improved growth outlook and diminished political risks, the euro area still has low levels of inflation and plenty of spare capacity and the currency now prices in a very optimistic outlook for Europe compared to the U.S. and the UK. Although European sovereign bond markets may come under pressure from an eventual reduction in central bank purchases, our analysis of the European interest rate swap curve suggests the market is already pricing in terminal rates* of around 2%, which is higher than Japan and the UK, and similar to the U.S.
The chart below shows the implied path of interest rates in Europe, the U.S., UK and Japan based on overnight index swaps**. This suggests to us that the market may currently be too fearful of the impact of tapering on longer term yields as indicated by expectations of 2% interest rates in 10 years’ time. The market may also be assigning too little probability to near‑term interest rate hikes, given the relatively shallow trajectory of the curve over the next five years.
Implied future path of interest rates
In summary, the market will, of course, continue to watch with interest for indications of future policy direction ahead of the October meeting and we expect current interest rate expectations to be subject to revision.
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*Terminal rate: what the economists call the natural or neutral interest rate — the rate that is consistent with full employment and capacity utilization and stable prices.
**Overnight index swap (OIS): an interest rate swap whose floating leg is tied to an overnight interest rate such as the overnight Federal Funds rate in the US, EONIA (euro) or SONIA (sterling). The rate is compounded over specific time periods. OIS swap rates are useful in gauging market conditions as they measure rates traded in the market.