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December’s ECB verdict and sovereign yields

In the previous monetary policy committee meeting, the European Central Bank (ECB) indicated that in December's meeting some sort of movement in monetary policy would be communicated.

In fact, as promised a change was announced yesterday and to a certain extent the market reaction was positive. In addition, this week was also characterised by the Italian referendum, which led to the resignation of Matteo Renzi from his position following the humiliating defeat of a ‘No vote’ for reforms.

Surprisingly, following the news, markets reacted positively and in fact we’ve experienced a building momentum to yesterday's important ECB meeting.

In the build-up, markets were anxiously awaiting some form of further support by the ECB in re-assuring his presence through market operations in order to push the Eurozone towards his two per cent inflation target.

Interestingly enough it was the EUR/USD which traded flat on Wednesday, as traders awaited yesterday’s meeting, despite the surge of circa two per cent following Sunday's referendum verdict in Italy.

Prior to yesterday's meeting market participants were expecting the ECB to extend its QE program, in line with the yet to be achieved inflation level. Other than that, following the outcome the build-up towards the meeting was also justified as markets expected increased stimulus following the referendum outcome.

Therefore, the surprise was not the extended period of its quantitative easing (QE) programme until December 2017, but the reduction in monthly purchases from €80bn to €60bn. The initial market reaction was a spike in the EUR/USD which touched highs of 1.081.

Despite the statement issued by the governing council always triggers initial market reaction, the press conference is a stronger element in terms of market movement.

In fact, following the re-assurance from Draghi in the press conference that the ECB will intervene if necessary, apart from the fact that tapering wasn’t discussed unanimously, we saw a reversal in the EUR/USD towards the 1.063 level, as the market digested a dovish stance by the ECB.

From yesterday’s comments, Draghi was crystal clear to state that the ECB will once again re-tweak its program if market conditions deteriorate.

In my view, the recent movement in sovereign yields is justified due to the recent uptick in inflation. For the sake of clarity market participants always try to act in anticipation and the recent re-pricing yields is in line with the market expecting a reduction in QE going forward.

The other important decision taken by the ECB is the removal of the previous constraint in its asset purchasing program of not buying bonds which hold a yield below the -0.4 per cent deposit rate.

This implies that the ECB will no longer be confronted with increasing long duration bonds on its balance sheet. This is also another point to consider seriously for investors holding long duration bonds. As a matter of fact, yesterday’s initial reaction were rising yields for bonds with maturities longer than 2-years.

Inflation forecasts by the ECB for 2019 are expected to be 1.7 per cent, thus still below 2 per cent. That said once again let’s highlight the important fact that markets commence pricing in anticipation and thus portfolio re-alignment is crucial.

Locally, investors who for the past years were faithful to local Malta Government Stocks (MGS), which in actual fact provided strong capital gains, should by now have understood that what was experienced over the past years, is not sustainable going forward.

For the first time in years, the Central Bank was bidding at levels below par for the latest 2.1 per cent 2039 issue. Understandably, the pricing was reflecting steeper sovereign curves in Europe as increased inflation expectations rose which in turn translate in monetary tightening. Thus, moving forward in my view it is imperative to primarily reduce long-dated MGS in order to avoid further capital depletion going forward.

Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

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