Treasurers weekly briefing

Markets were surprised by the ECB response to subdued inflation, on Thursday cutting the Refi Rate to 25bp, leaving the Deposit Rate at 0% and cutting the Marginal Lending Rate to 75bp. The Refi Rate cut caused bull flattening of the money market curve and the EUR 5s30s to steepen to 10 year highs. Some who had expected gradual steepening of the curve, now see the curve as overly stretched and recommend taking profits.

Importantly the ECB kept its forward guidance policy unchanged, supporting “low or lower” policy rates. Mr Draghi also stressed that inflation will remain low for a prolonged period and that the ECB has an array of options open to it to ease further. But according to the ECB this Thursday’s rate cut keeps risks to medium- term inflation “broadly balanced.” That can be construed as implying that negative deposit rates are not imminent.

Apart from the cut itself, the decision to move reveals Mr Draghi’s strength on the Governing Council with news reports that certain ECB members such as Asmussen and Weidmann wanted to wait until December for more data. That said, the last ECB rate cut was six months ago (in May) and it could be a while before the next response. Key indicators may be the Euroland PMIs on 21 November and HICP inflation on 29 November with the possibility that inflation troughed in October and may rise to 0.9% in November. Current projections are for inflation to average 1.3% in 2014 and in December the ECB will update its forecast and provide 2015 data. We can expect perhaps 1.2% for 2014 and 1.3%-1.4% for 2015. These sorts of numbers would be low enough and for long enough to keep the ECB supporting easy money.

As for possibility of negative deposit rates in Euroland, the ECB signalled that it will cut to negative territory if deflation risks are imminent. The ECB has a very narrow definition of deflation: “… a self-fulfilling fall in prices across a very large category of goods and across a very significant number of countries…” But on the issue of what is self-fulfilling, if the ECB signals concern on deflation, then it is more likely that the market will believe and price it in, and changing market expectations after that may be a hard task. Accordingly negative deposit rates may well not be seen.

In terms of the policy context, the Refi cut can be seen as a substitution for a liquidity injection and any further LTRO is only likely after the AQR’s liquidity risk assessment, which is expected to be released in Q2-Q3 2014. Against this backcloth, Euroland rates may gradually grind lower as the ECB reiterates its dovish stance.

Turning to the week ahead, for the UK, we’re due inflation (PPI, CPI and RPI) data for October on Tuesday, jobs and average earnings numbers on Wednesday, and retail sales for October on Thursday. But arguably the highlight will be the Bank of England’s Inflation Report on Wednesday. Their forecast for Q2 GDP growth was 0.5%±0.3%, so the preliminary figure of 0.8% is at the top end of their expectations. As a result we may expect that their GDP projections will revised upwards and discussion of improving growth may be bearish for gilts over the very short term. Equally the last Report projected unemployment to reach the 7% target in mid 2016, but the MPC minutes have already started signalling that it could fall faster than they previously projected. The last Inflation Report also highlighted the divergence in output and employment from 2010 up to Q1 2013 but recent data suggest that productivity growth may be returning to normal, as expected by the MPC. If this proves to be the case, unemployment can be expected to fall less rapidly than the pace of recovery would otherwise suggest.

As for inflation itself, the BoE’s median 2 year CPI forecast was for 2.1% in the last Report but recent currency strength and falling commodity prices (in Sterling terms) should put downward pressure on this figure.

The practical implications of these developments are that Mr Carney may maintain a non-interventionist stance, with the currency and rates beyond the very front end being allowed to rise without action by the Bank. We should expect that markets will keep challenging the BoE’s accommodative intentions so long as economic news stays positive, and if the estimated breech of the 7% threshold is brought forward to end-2015, we would see that as bearish for UK rates, especially the 5 year sector and there remains scope for the three year to thirty year curve to steepen, especially if the Inflation Report has a dovish emphasis. As a short term technical aside, net gilt supply for the next four weeks is moderate in size and well spread over 5, 10, 20 and 30 year issues so this should have little overall effect on the curve. There is no linker supply over the period, which should be supportive of cash break-evens.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla