The world is not yet facing a systemic crisis but risks are rising. There are mitigating factors compared with previous systemic crises but there are also concerns about declining market liquidity, central bank fatigue and the slowdown in emerging markets.
Italian and Portuguese banks are facing rising NPLs but the main concern for the ECB is the collapse in inflation expectations. As a result, we adjust our call on the ECB. We now expect it to accompany a 10bp rate cut with (1) the introduction of a two-tier deposit rate system and (2) front-loading of the current QE programme.
We have also changed our call on the Fed and now expect it to keep rates on hold until the September meeting. We expect one hike in 2016 and three hikes in 2017.
Near term, we expect EUR/USD to range trade, as high risk aversion counterweighs relative interest rates. Medium term, we maintain our long-held view that EUR/USD will head substantially higher due to a range of fundamental factors.
We expect more ECB QE to support a flatter Bund curve, while the ASW spread should fall. The hunt for yields should push investors back to short-end periphery bonds.
Short term, we recommend equity investors reduce their exposure to European and US equities, as it will require a co-ordinated policy response to end the sell-off.
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