Will the European Central Bank turn more dovish?

After the Bank of Canada’s rate rise last week, markets are primed for the next stage in central banks’ retreat from quantitative easing. Bonds have been selling off in anticipation of a return to normalisation, although the support for equities and bonds in response to the tone of Federal Reserve chair Janet Yellen’s comments to US Congress about inflation suggest the pace will be slow and erratic. The ECB last month offered some pointers towards tightening, which helped propel the euro to a 14-month high against the dollar. Mario Draghi, ECB president, will not want to trigger much more appetite for the currency, so any remarks about the strength of the economy will be tempered with caution about the tapering timeframe. Still, analysts at Nomura expect the ECB to drop a commitment it has had towards expanding its asset purchase programme. Investors are gearing up for a possible ECB announcement on September 7 that tapering will begin next year, and Mr Draghi’s appearance at the Jackson Hole symposium in Wyoming in late August will warrant close attention. By then, the ECB will have accumulated further evidence on inflation and the prospect of hitting its 2 per cent target. The BoC is relaxed about its hitting its target. Ms Yellen is more circumspect. Investors want to know where Mr Draghi sits. Roger Blitz
Will rising bond yields threaten eurozone equities?
Over the past week eurozone equities have resumed outperforming their US counterparts after a wobble in late June. Analysts at BNP Paribas caution that a bout of sharply rising real yields threatens equity prices and could well leave the Euro Stoxx 50 lagging the S&P 500 as we saw during periods of turmoil in the fixed 2013 and 2015. “The direction in equity markets in the second half of the year could largely depend on where the bond market heads, and that investors may need to reprice to higher bond yields,’’ the analysts say. For much of 2017, eurozone equities have outperformed the S&P 500, encouraging strong fund flows into the single currency region. “A sharp and sustained period of rising real yields in Europe could, therefore, potentially adversely affect the performance of the Euro Stoxx 50,’’ adds the bank. “Going long, S&P 500 and short Euro Stoxx 50 over the summer may be an alternative if investors think real yields will continue to rise sharply and eat into equity risk premia.’’ Michael Mackenzie
Is the US dollar primed for further weakness?
Dollar doldrums have dominated the currency market this year, and there appears little sign of that changing. The index measuring the dollar against its main peers has fallen to its lowest level since September on a combination of factors, including Trump trade disappointment and Federal Reserve caution. Signs of other central banks normalising policy are also weakening the dollar, while Friday’s disappointing inflation and retail data has taken the wind out of the sails in the US economy.
Little wonder, as Bank of Montreal’s Stephen Gallo points out, that net long positions held by leveraged funds have fallen seven weeks in a row. At least the Bank of Japan’s unrelenting pursuit of monetary easing gives the dollar one main currency to lord it over — the yen has fallen more than 3 per cent in the past month. Elsewhere, however, the dollar is looking in the other direction. Emerging market currencies are on the march, helped by improvements in their countries’ own fundamentals. In a climate of rising global interest rates, risk appetites would normally be suppressed, says BNY Mellon’s Neil Mellor, but Fed caution “may have given risk-taking a new lease of life”. That entails further dollar declines. Roger Blitz
Can the UK weather Brexit without a spike in borrowing costs?
Last month’s surprise UK election result heralded a shift in public opinion away from austerity, something which now poses a headache for the Treasury as it ponders how to balance the books with the country negotiating its departure from the EU. On Friday the release of the first data on public finances to cover the period after the election may provide an early glimpse of the challenges that chancellor Philip Hammond faces in drawing up his Budget this autumn. A key risk is deficit projections being revised upwards. John Stopford, global head of fixed income at Investec Asset Management, can envisage a gilt market reaction “if they do the full Corbyn and really throw the kitchen sink at it” — spending at levels promised by the Labour party’s election manifesto. But “at the moment it does not look as though borrowing will get out of control”. Any market reaction to an increase in gilt issuance would be focused at the long end of the yield curve, he predicts. Mark Capleton, head of research into inflation-linked securities at Bank of America Merrill Lynch, flags the declining range of gilt buyers in the market as a potential concern. Pension funds are “the only dependable [domestic] buyers”, he says, and as they become cash flow-negative — payouts exceeding contributions — they can “only buy gilts by switching from other assets”. If the government were to have “persistent large gilt financing needs” it may need to shift its issuance to shorter maturities as “there are always willing buyers at the front end of the curve”, he adds. Kate Allen