Back in April I wrote that I believed the European Central Bank (ECB) would take its key interest rate beyond 3.75% to 4% and potentially beyond (see here). The ECB did indeed hike to 4% in June, where we currently stand, and pre-warned in early August that they would likely move to 4.25% at their September meeting.
However, the recent volatility and economic data have market participants questioning either the likelihood or indeed requirement for a hike come September. Whilst the futures market is still implying a very high likelihood of a hike, I believe the ultimate outcome is more balanced. Though if you pushed me into a corner I’d agree we will probably see the ECB move to 4.25% and stop.
On the one hand the ECB believes that it must target inflation risks over the medium term to ensure price stability and that the risks remain to the upside. Also liquidity (at least until recently) has remained high and interest rates are not in the ECB’s mind, as yet, in restrictive territory. Furthermore, capacity utilization in the Euro zone continues to remain at historically high levels. However, the ECB can’t ignore the recent re-pricing of risk (albeit they have been trying for some time to remove liquidity to prevent asset bubbles), the loss of confidence by some and the obvious pain felt by many. Infact the ECB have been very active in recent days, injecting funds to try and calm the short term commercial paper and overnight deposit markets. Furthermore the ECB will also have to take into account the recent slowdown in GDP (from an annualised rate of 2.5% to 3.1% in Q2).
The likelihood of an emergency cut from the Fed has been much touted of late. I’m not suggesting that Fed policy will dictate to the ECB, however, if we were to see Fed cuts then the ECB may find it that bit more difficult to hike.
So what does all this mean for the European Corporate Bond Fund? I decided last week to begin reducing my short duration position and am targeting a flat duration position for now. As ever, I’ll be keeping a close eye as events unfold.