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Shawn Baldwin analysis on potential volatility

Shawn Baldwin discusses potential Quantitative Easing by ECB Chief Mario Draghi

Shawn Baldwin analysis on potential volatility
Shawn Baldwin, Chairman AIA Group, with European Central Bank President Mario Draghi

(Frankfurt, Germany) Today the European Central Bank (ECB) President Mario Draghi in a press conference from Malta, conveyed that the bond markets are in a period of heightened volatility due to the extremely low interest rate environment.

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The ex- Goldman Sachs investment banker comments hinted that more stimulus in the form of quantitative easing was on the way. Draghi left his options open on increasing and/or lengthening the asset-buying program if needed to get inflation back toward the target of near or just below 2%. To be clear: weakening the euro is one of the few tools that the ECB has to use.

Draghi’s comments caused a sell­off in Bunds (the German 10­ year bonds) resulting in yields spiking to their highest levels since October, to as much as 0.897%, the equivalent of a 32 basis points move in two sessions, an increase not seen since 1998. Simultaneously, 10­ year Treasury yields increased by 11 basis points, rising to 2.37%, a level not seen since November.

For now, the ECB chief has left interest rates on hold, with Super Mario saying that the bank will reassess whether to extend its massive bond-buying program at year end. Draghi left the door open for more monetary stimulus but actually stopped short of announcing any new policy measures, while stating that they will be “re-examined in December” since inflation continues to be persistently low amid emerging market weakness.

After euro area inflation had a negative downturn in September and the ECB downgraded its growth forecasts for the next two years, the tactical solution to most seemed to be more quantitative easing. Draghi’s comments drove the euro sharply lower and stocks markets higher.

Investors that have been pressing the ECB to increase its 60 billion euro per month stimulus program, will seemingly have to wait until December. However, even then investors should not expect quantitative easing (QE) to have the dramatic effect that it has had in the past. Actually, it is prudent to expect the effects to lessen as we continue forward. In opposition to this line of thinking, a number of senior economists and institutional investors still expect the U.S. Federal Reserve to hike rates for the first time in nearly a decade in December.

If the ECB’s policies are to have maximum effect on the exchange rate, a point that the ECB Chief reiterated is not a policy target–then the most efficacious measure would be to loosen as the Fed tightens. This should cause the euro to weaken significantly, causing exports to be cheaper and making imports more costly, this could potentially help to increase inflation up from zero. So If the Fed hikes, we will see a natural depreciation of the euro. If the Fed doesn’t hike this year, Draghi should be able to simply talk the exchange rate down to prohibit the euro from rising too much.

D-day for action from the ECB will be on December 3rd. From a logistical standpoint, the ECB meets before the Federal Reserve Bank does in December, so it won’t be crystal clear as to what Chairwoman Yellen has decided when they have to make their decision to ease. This is a concern because there are still some economists who have doubts as to whether the Fed will actually pull the trigger, causing some analysts to not expect a move until 2016.

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Most market analysts expect that the euro will fall over 7 percent against the dollar over the course of the next 12 months, so the mantra is long dollar versus a euro short. If this turns out to be the case, the euro will have dropped more than 20 percent of its value from 2014 and 2015, that would be the first time since its creation that it has decreased more than 10% in two consecutive years.

This might seem egregious to some, however it will become a clearer scenario for investors if the Fed lifts rates off the zero bound interest rate.

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About the author

Shawn D. Baldwin is Chairman of the AIA Group (AIA), an alternative investment and advisory firm based in Chicago.

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