On Wednesday and Thursday, we had two very different messages from two of the world’s largest central banks. First the minutes from March’s Federal Reserve meeting revealing that the Federal Reserve will look to start to shrink the central bank’s balance sheet later this year. This revelation along with a weaker than expected Institute for Supply Management manufacturing purchasing managers survey, led to a 200-point reversal in the Dow Jones index on Wednesday evening. The shrinking of the Fed’s balance sheet is in effect quantitative easing in reverse. If quantitative easing artificially supressed yields on treasury bonds, then the possibility of the opposite should cause a spike in yields. However, this was not the case, yields on ten year treasuries hardly moved.
Next it was the turn of Mario Draghi, speaking in Frankfurt on Thursday, and in contrast to the Federal Reserve played down the possibility of withdrawing the European Central Banks monetary stimulus policy. The first half of the speech was dedicated to an exercise in justifying the policy, and the impact quantitative easing policy has had on the recovery in the euro area. Mr Draghi making this speech in Germany continues to highlight the tensions the ECB’s current monetary policy is causing within Europe. Several senior German finance ministers have been on record in the past few days calling for the withdrawal of some of this current monetary stimulus, over concerns inflation will continue to rise. The German economy is at full employment whereas the euro area, as a whole, is still a long way from that.
Capital markets remains a conflicted one. Bonds remain in demand, continuing to suggest risk aversion. Lower bond yields suggest caution for the outlook for inflation and growth, but at the same time adds to the attraction of equities. Some sentiment indicators suggest euphoria is still a way away, others such as the Wells/Fargo Gallup survey reported that investor optimism has risen to its highest level since the dot com boom. Barron’s compile a composite of several sentiment index readings. Currently their sentiment index stands at 70, slightly lower than it was a few weeks ago, and just below the 75 level they consider suggests sentiment is becoming overly optimistic.
Yields on UK gilts and German Bunds remain below current inflation rates in these regions. Anyone who wishes to buy this debt would rather an almost certain loss of capital against risking it in the equity market. Again, hardly a sign of euphoria and should also provide something of an underpinning during equity selloffs. It is worth bearing in mind ultimately with capital markets bonds are the dog and equities the tail.