Diverging paths for the US and euro area

Central banks to the rescue once again. The episodes of instability dotting the global economic-financial scenario between July and August (geopolitical conflicts in Russia and the Middle East, slumps in activity in the euro area and China) were easily extinguished by the appearance of the central banks on the scene. On this occasion the key player was the European Central Bank (ECB), although the central banks of Japan and China also helped out. By announcing various monetary measures and using rhetoric, they managed to placate the outbreaks of volatility in the different financial asset markets while the Federal Reserve (Fed) has remained firmly in the background. However, the disparate tone of cyclical indicators over the last few weeks between countries augurs an autumn full of news in the monetary area. In the US, investors expect the Fed to follow its roadmap, completing its tapering in October and planning the first interest rate hike for mid-2015. In the short and medium term, the market trend is characterised by greater level of volatility, largely due to this growing divergence in the orientation of monetary policy between the US and the euro area.

On the verge of ending tapering, the Fed ratifies its dovish tone. At the first meeting of the FOMC (the committee
in charge of monetary policy decisions) after the summer break, two familiar basic messages were repeated outlining its strategy. Firstly the plan is for interest rates to remain at a low level for «considerable time» after tapering ends in October and, secondly, the reason is that resources in the labour market are still considerably underused. However, the FOMC members suggested a slightly faster rise in the official interest rate than in previous meetings. Monetary conditions being tightened up sooner than expected would be the result, primarily, of a scenario in which the reduction in idle labour resources was faster than expected, but also of greater risks jeopardising controlled inflation or financial stability (the formation of bubbles). In this respect, the institution is likely to clarify its strategy regarding developments in the official interest rate at its next meeting on 29 October.

The ECB adds more fuel to the fire. In an unexpected move, the Governing Council of the ECB decided to cut the official interest rate to 0.05%, as well as the marginal lending facility and deposit rate to 0.30% and –0.20% respectively. Moreover, Mario Draghi announced the launch of a dual private debt purchase programme which will start in October: over the next two years the institution will acquire mortgage-backed securities and asset-backed securities from companies in the euro area, as well as buying up covered bonds. Although these decisions were not unanimously supported by the members of the Governing Council, their adoption was in response to the deterioration in inflation expectations in the medium term and to weakening economic activity. Similarly, in September the first targeted long-term refinancing operation or TLTRO was carried out, which met with a modest demand for funds: 82.6 billion euros, clearly below the forecasts of the consensus of analysts. This circumstance has raised doubts among investors as to whether the benchmark established by the ECB itself can be reached, namely expanding its balance sheet by approximately one billion euros. The ECB has said it is prepared to take the necessary measures to achieve its ultimate objectives but it is most likely to wait a reasonable period of time before evaluating the overall effectiveness of its latest expansionary measures and proposing new areas of action.

Investors go for long-term treasuries. The conflicts occurring during the summer in the Middle East and Ukraine, as well as recent tensions in Hong Kong, have increased the preference of participants for safer assets, particularly US public debt and, specifically, debt with the longest maturities. The absence of any significant inflationary pressures in the US and the intensification of monetary stimuli in the EMU and in Japan have encouraged this behaviour. Paradoxically, the tranquillity now reigning in the US government bond market represents an area of vulnerability. The possibility of faster hikes in the official interest rate than currently expected, based on the apparent increase in long speculative positions in treasuries, are making the panorama more fragile.

Minimal yield on the Bund. The weakness of Europe's economic scenario is affecting its sovereign debt market.
The economic slump suffered in Q2 by the core economies (Germany and France) is in addition to the confirmed slowdown in the euro area's inflation in September. Such figures have helped to push down the German interest rate curve even further. Specifically, one, two and three-year bonds offer a negative return while the yield on 10-year
bonds is still below 1%.

Investors embrace sovereign debt from the periphery. Having overcome the modest upsets of the summer (the
BES crisis in Portugal and Italy's double-dip recession), yields on public debt from the periphery of Europe have once again started to fall (i.e. higher prices). The outcome of the referendum on Scottish independence has also encouraged investors to take on more risk. This trend has also been helped by the announcement of extraordinary liquidity measures by the ECB in September and could become even stronger should the central bank ultimately add to the package of measures over the coming months. Another factor to take into account is the publication of the stress test results for European banks at the end of October, which should reduce uncertainty regarding the sector without causing any upsets. Because of these tests, banks have considerably increased their issuances of contingent convertible bonds to improve their solvency ratios.

Gains and losses in the stock markets due to doubts regarding growth in the EMU and emerging economies. After the ups and downs seen during the summer, caution dominated the stock markets in September. The overall tone has been weak, albeit with notable differences between countries depending on their respective macroeconomic and monetary developments. Japan and the US have provided the positive note. In Japan, because investors expect another round of expansionary measures by the central bank and, in the US, thanks to the support provided by the recent good figures. Stock markets in the euro area and the emerging countries have recorded moderate corrections while, in the emerging block, doubts have been raised regarding China's economic growth although the central bank has responded quickly by injecting liquidity into the country's five largest banks. The uncertainty regarding Brazil's presidential elections, deterioration in the Russian macroeconomic scenario and altercations in Hong Kong have tipped the balance over to the side of losses. In spite of this, the medium-term outlook for the stock markets is favourable. The gradual improvement in global growth and the prolongation of accommodative monetary conditions on the whole should support this upward scenario.

Strength of the dollar against the euro and widespread weakness in commodities. The euro's exchange rate against the dollar has fallen to 1.26, a level not seen since 2012. The main reason for the euro's continuing depreciation is the divergence of monetary policy between the euro area and the US. In the emerging area, pressure on the Brazilian real and Russian rouble has increased. In the first case this was due to uncertainty regarding the elections that will take place in October while, in the second, it is the result of capital outflows and rumours regarding the possible establishment of exchange rate controls. Commodity prices in general, and oil in particular, are continuing their downward trend. The strength of the dollar, oversupply and an expected drop in demand for crude have pushed the price of a barrel to clearly below 100 dollars.