*By Christophe Barraud, Chief Economist & Strategist at Market Securities
According to TrackInsight data, since the beginning of the year, investors have accumulated “European Bonds” ETFs with inflows hitting a new YTD high. The trend strengthened over the last few days although the ECB said last week that rates will remain at their present levels at least through the first half of 2020.
Even if the latest ECB meeting was perceived as somehow hawkish by market participants due to no concrete commitment to ease monetary policy soon, investors are betting that the ECB is bluffing and will probably cut rates by year-end (55% probability according to Bloomberg pricer). Note that key factors could force the ECB to revise quickly its position:
First of all, as I noted last week, the U.S. Federal Reserve is on track to cut interest in the coming months, which should translate into weaker USD. As a reminder, the latest employment report (published on Friday) was disappointing with employers hiring the fewest workers in three months and wage gains cooling. In addition, yesterday, a closely watched measure of U.S. inflation trailed forecasts in May. The core consumer price index rose 0.1% from the previous month for a fourth straight time, missing estimates of a 0.2% gain. In this context, an aggressive easing move — that could spread to other central banks — would push the ECB to react in a context where a source told Reuters that “countering the euro’s strength, rather than lowering already rock-bottom borrowing costs, would be the main reason for a further cut to that deposit rate”.
Secondly, Eurozone inflation expectations (5Y/5Y) have collapsed and reached a record low today. They fell below 1.20%, far away from the ECB mandate, namely close but below 2%.
Thirdly, ECB forecasts on both growth and inflation are subjected to significant downside risks. Key economies in the area (Germany and Italy) remain very sensitive to global trade growth which, according to my estimates, will remain under pressure at least until 3Q 2019. In addition, Eurozone “auto & parts” exports to the U.S. could be affected by tariffs in November if ongoing negotiations fail.
Finally, since yesterday, the probability of a Hard Brexit scenario has increased with MPs voting against a cross-party motion that would have offered the possibility to block a no-deal Brexit before the new Conservative leader enters Downing Street.
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