Markets’ reaction to Trump gives ECB breathing space

Amid all the attempts to guess what Donald Trump’s election means for Europe’s trade, security and populist politicians, one conclusion stands out: his administration may be good news for the European Central Bank, reports the Financial Times

The reason is not any particular act by the president-elect; rather, it is the reaction of markets, which could help the European economy and give the central bank more room to act.

Foreign exchange provides one example. The euro has weakened 3 per cent against the dollar since election day, to trade at the lowest level of 2016. “The move in the currency is clearly quite helpful,” says Mike Amey, portfolio manager at Pimco, the bond specialist.

A weaker currency, while it is not an explicit aim of the ECB, helps exporters at a time when the central bank is trying to stimulate economic growth and inflation.

European bond yields, particularly for longer-dated debt, have moved sharply upwards since November 8.

In part this is because Treasury yields have jumped as investors worry that Republican tax cuts and spending plans will cause inflation to rise.

But the moves also reflect a shift away from the politics of austerity, with a rising chance of increased government spending while short-term interest rates remain low thanks to central bank policies.

“People aren’t revising yet their global interest rate expectations, but they are revising their fiscal policy assumptions,” says Charlie Diebel, head of rates for Aviva Investors.

Given fixed coupon payments, a bond’s value is vulnerable to inflation, and prices fall as yields rise. Higher yields for long-dated euro bonds thus suggest that investors see at least the risk of inflation returning.

Such movement erodes the effect of the ECB policy of buying €80bn of securities a month to suppress borrowing costs. But it also gives policymakers breathing space.

For most of the year a crunch had been looming because of rules that govern the ECB purchases. The money is split between the 19 members of the eurozone according to a strict formula, on top of other restrictions to do with the price and type of securities.

As yields dropped below zero for the safest bonds, it began to look likely that the ECB would run out of German bonds to buy, either constraining its ability to act or forcing a rule change.

Six weeks ago the volume of Bunds that met the ECB’s criteria had fallen to about €300bn. Now it is €600bn.

Frederik Ducrozet, senior economist at Pictet, estimates that the sell-off in eurozone government bond markets has bought the ECB six months of asset purchases. He also said the central bank might announce a new round of bond purchases to bolster the economy.

Yields, meanwhile, remain depressed by historical standards, with the German benchmark bond offering income of just 0.3 per cent a year for a decade.

Vítor Constâncio, ECB vice-president, sounded a warning on Monday. Eurozone core inflation was “not recovering” and rising protectionism could damp any spillover from an acceleration in the US economy, he said.

Europe has had prematurely rising yields before. In April 2011 the ECB was the first big monetary authority to raise interest rates, to 1.25 per cent. Three months later, as the debt crisis gathered strength, it did so again, only to reverse course not long after.

“In the US the market is saying inflation will return,” says Mr Ducrozet. “In the eurozone the market is reflecting contagion. There is nothing in the economy that justifies the moves up in yields. We are still in the second leg of the eurozone’s recovery and I think this move higher in yields will be seen as unwelcome tightening.”

Marie-Anne Allier, head of euro fixed income at Amundi, points to the growing gap in borrowing costs for Germany and Italy, where the 10-year is above 2 per cent. “At some point the ECB will have to do something,” she says.

That point may come at an ECB meeting days after an Italian constitutional referendum — the next opportunity for voters to register discontent with the status quo.