End Of Lower Interest Rates In Europe Begins
European central banks are partially tightening financial conditions, a Deutsche Bank report observes, a move that would imply “higher volatility, lower equities, higher real rates and wider credit spreads.” Typically, a rising interest rate environment would also spark a rally in the correlated currency market, but this might not happen this time as lower interest rates end, the report predicted, pointing to numerous regions addressing the same issues at the same time.
Lower Interest Rates - Central bankers are explicit it sends a message
There has been an oddly subsuming low volatility market environment that has been the subject of much analyst speculation. Deutsche Bank’s Francis Yared, Jack Di-Lizia, Abhishek Singhania and Markus Heider look at Europe and think a change may come sooner rather than later.
The speculation that volatility could heat up comes as Goldman Sachs European analysts recently predicted another year of a low volatility environment dominating market action and leading to favored investments in European stocks.
Saying that notoriously unclear central bankers have “made relatively explicit statements,” the report points to several central bankers who indicate the beginning of the end is a cycle is at hand. San Francisco Federal Reserve Bank President John Williams saying that "the stock market seems to be running pretty much on fumes" is an indication that market volatility could be expected in the future.
The beginning of the end of lower interest rates in Europe
On the European economic plateau, central bankers in the land of negative interest rates are, likewise, noting a beginning to the end. That assessment is in part driven by a correlation breakdown.
“We've seen quite a disconnect in the past month between the equity markets and bond markets globally," European Central Bank board member Benoit Coeure said last week in Frankfurt, a quote highlighted in the Deutsche Bank report and attributed to hawkish statements made by ECB President Mario Draghi.
While Coeure made the statements in the context of a temporary reaction to those statements Draghi, Deutsche Bank is pointing to a potential policy change coming out of the ECB. Specifically, the report highlights Draghi’s statement that “the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged,” was pointed to as a potential beginning of the end of hyper-aggressive interest rate repression.
The first step to ending ECB negative interest rates is to stop buying bonds
The first step towards ending an addiction is stopping the offending behavior. That is what Deutsche Bank seems to think is currently happening in Europe.
“Central banks seem to be at least partially targeting tighter financial conditions,” the report opined, pointing to a potential policy trend reversal which may be underway. To reverse the trend in central bank bond purchases – which in Europe have included purchasing corporate bonds in addition to buying on the long end of the government yield curve -- is to stop the existing buying trend.
This perceived plan to eventually reverse the ECB’s interest rate momentum comes as Deutsche Bank thinks market participants are long rates and risk assets.
“Central banks are leaning against market positioning, but are constrained by the inflation outlook,” with a rise in inflation potentially signaling a quicker pace to normalization, which is in part the Crispin Odey thesis.
Analyzing the market requires a nuanced understanding that connected sometimes traditionally unrelated. While inflation has surprised to the downside in Europe to date, the trend implied by leading indicators is pointing to higher inflation down the road, which has an impact on interest rates. “Valuations metrics suggest that the term premium is too low,” which to the markets makes a potential “upside surprise” in the form of inflation coming on the back of wage gains “generating a second leg to the upward repricing of the risk premium.”
Unlike Goldman Sachs, which says the central bank dance has another year to play itself out, Deutsche Bank looks at Europe and is specifically watching for a surprise pick-up in inflation to break the low volatility pattern.
However, if David Einhorn's "prophecy" from 2011 (shown below) is correct Lower Interest Rates could last a lot long.
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