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Jim Leaviss: Could the ECB move to full-blown QE?

The ECB is finally responding to the threat of deflation across the eurozone

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Central bank watching has always been a very important part of bond fund management because of the obvious implications that monetary policy has on bond yields.

Never before though have central banks been under so much scrutiny as they are today, and never before have they been so communicative – you just need to look at the amount of words in statements from the Federal Open Market Committee, which has increased four-fold from the pre-crisis era to now.

There is no doubt we are at a very interesting point in the interest rate cycle right now and we could soon have quite divergent monetary policy across some of the major central banks, with the UK and US preparing to hike while the European Central Bank and Bank of Japan continue to ease.

Although growth is currently stronger among major economies in the UK and US, I expect the Bank of England and Federal Reserve will continue to give the recovery the benefit of doubt and leave interest rates unchanged for now.

However, given the encouraging outlooks for both economies, markets may need to bring forward their expectations for the timing of rate rises to earlier in 2015 than previously anticipated. This is particularly so in the UK where a surprisingly strong recovery continues to be evident and the possibility of a rate hike before the end of 2014 cannot be ruled out.

In the longer term, the market appears to be pricing in the 10-year US Treasury yield rising to be just under 3.5 per cent in 10 years’ time, a little lower than the median expectations among the Federal Open Market Committee members. I expect the most likely catalyst to make the Fed raise rates would be the emergence of worrying signals on inflation.

For over a year now, the Personal Consumption Expenditure measure of prices, also known as the Core PCE Deflator and the Fed’s preferred indicator, has remained significantly below its target level of 2 per cent. This low inflation environment, which was partly driven by wage growth stagnation, has made the Fed unlikely to respond to lower unemployment and growth in gross domestic product with higher interest rates.

Importantly, however, the US’s growth momentum could now be strong enough to begin to feed through to higher inflation going forward, as unemployment has continued to fall and wages have begun to increase (albeit only modestly), and we have seen a slight pick-up in various measures of US inflation over the summer.

Thanks to the BoJ’s massive stimulus program, even Japan has recently seen a rebound in inflation, and at 2.3 per cent for August surprisingly now has the highest core inflation in the developed world. Obviously time will tell, but Abenomics seems to be working so far.

In contrast, the risk of deflation has become an increasing concern in the eurozone region, driven by high unemployment, austerity measures, low wage growth, and the output gap. Eurozone inflation has been on a worrying downward trend, falling steadily from a peak of 3 per cent at the end of 2011 to just 0.4 per cent in August this year.

The ECB has finally responded with measures that included an historic reduction of the deposit interest rate to below zero, a targeted longer-term refinancing operation, which offers banks access to cheap money for the long term, and an asset-backed securities and covered bond purchase program that will begin in October. The question is whether these recent measures will be enough to get Europe out of the mire.

The take-up at the September TLTRO was disappointing, with just over €80bn (£62bn) allotted, which was less than half the amount banks were expected to bid for. Critics of the ABS programme also point to the fact that the pool of assets available to buy is rather limited. So the ECB may have difficulty in expanding its balance sheet enough through these measures alone, which means it may ultimately have to go down the same route as the Fed, the Bank of England and the Bank of Japan, with full-blown quantitative easing.

Jim Leaviss is manager of the M&G Global Macro Bond fund

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