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Central bankers prepare for the mountain trails

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The Ghost of Financial Crises Past has been splashing itself across the broadsheets in recent weeks, and not without reason. Last Wednesday marked the ten-year anniversary of the event that many would class as the start of the subprime crash proper. On 9 August 2007, BNP Paribas decided to halt redemptions in three funds that were exposed to US mortgages, citing a “complete evaporation of liquidity in certain segments of the US securitization market”.

Their concern was understandable. Over the preceding weeks, the major institutional players had finally started to wake up to the fact that several of the assumptions that underlay the perceived safety of mortgage-backed securities did not hold water. House prices could go down as well as up and, if they did, it was not merely possible but in fact quite probable that all the holders of subprime mortgages would start to default at once. If that happened, the collateralised debt obligations that made up large portions of many of the major banks’ balance sheets would not just be illiquid – they would become virtually worthless. And the rest, as they say, is history.

Traders can be a superstitious bunch at the best of times, and the summer months don’t tend to bring out the best in them. Part of this, no doubt, is down to “too much sun and too much warm prosecco”, to which the Justice Secretary, David Lidington, memorably attributed the last few weeks’ stories of discontent within the Conservative party. More important, though, is the fact that there is simply much less liquidity in the markets, with many traders having closed out their positions in order to enjoy their summer holidays in peace. Add to this the fact that it is the more senior inhabitants of each trading floor who are the most likely to be away, and the resulting environment is ripe for even inconsequential news items to cause large price movements. If market participants are already feeling jittery from the memory of previous shocks, you have all the ingredients for a very volatile cocktail indeed.

With that in mind, there is significant potential for this year’s economic symposium at Jackson Hole (24-26 August) to cause an upset over the coming weeks. Hosted at a mountain retreat in Wyoming every year since 1982, the Jackson Hole symposium quickly became the venue of choice for Chairs of the US Federal Reserve to signal major policy shifts. In 2014, Mario Draghi decided to join the club, using his lunchtime address on the opening day of the conference to describe eurozone inflation expectations as having fallen “at all horizons”. Coming almost exactly two years after his promise to do “whatever it takes” to save the euro, the ECB President’s comments set the scene for his central bank’s quantitative easing programme, which started six months later. By the end of 2017, what it will have taken is €2.3 trillion in asset purchases and the introduction of negative interest rates across a group of countries accounting for nearly 20% of global GDP.

All eyes, therefore, will be on Draghi next week, as he returns to Jackson Hole for the first time since that 2014 speech. The ECB has spent the last three years battling against the prospect of eurozone deflation. Now, while consumer price increases are admittedly still below the target level of 2%, there are hints that the fight might soon be won. In late June, Draghi gave his strongest signal yet that the ECB might consider following the Federal Reserve and start to unwind its balance sheet, citing a “strengthening and broadening” recovery in the eurozone. The euro promptly embarked on a rally against most currencies, with EUR/USD (for instance) now sitting nearly 6% higher than its level just prior to his remarks. By comparison to its pre-QE level, however, the rally may still have a long way to go – particularly if Draghi uses next week’s speech to suggest that the ECB’s asset purchasing programme may finally be coming to an end.

Back home, the main thing to watch will be Tuesday morning’s release of the July CPI data, which has been the source of a few surprises in recent months. The expected year-on-year increase is 2.7%, although actual figures have been alternately over- and undershooting expectations for the last few releases. That said, UK interest rate expectations are becoming increasingly fatigued with inflation-related surprises, as it gets ever more apparent that the Bank of England will refuse to make any policy decisions until the Brexit negotiations start to take a more defined shape. For that, we may be waiting some time.

All views expressed here are the author’s own and are based on information and data available at the time of writing

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