“Leading central banks are shifting gears amid a rapidly evolving risk landscape. The ECB is striking a delicate balance, announcing the forthcoming end of quantitative easing while pledging to keep interest rates low. The Federal Reserve, in contrast, is signalling that faster rate hikes may be needed, given low US unemployment.

“The policy divergence is likely to contribute to US-dollar strength, a key risk factor for risky assets. Meanwhile, both the ECB and the Fed have warned that an escalation in US-China trade tensions could cause significant economic damage – a concern that is likely to shape monetary policy.

“Another worry for investors is how the EU will respond if the situation in Italy precipitates a Eurozone crisis. Although markets are taking a more sanguine view of Italian politics, the populist coalition’s policy agenda puts it on a collision course with the EU. We think it is highly likely that sentiment around Italy will deteriorate again in the coming months. The next big challenge could come in the autumn, when the Italian government is likely to announce its first budget.

“EU institutions are much better prepared for a crisis than they were in 2011/2012, but they remain untested – especially in the event of a problem the size of Italy. The ECB now has multiple tools at its disposal to deal with a crisis, but they all have the same flaw: political constraints could severely limit their use and effectiveness. “

Key implications

• Further divergence of US/European central bank policy could strengthen the US dollar. This is a key risk for risky assets, especially emerging markets
• Central-bank concern over US-China trade tensions is likely to shape monetary policy
• Italy remains a threat, and we think a re-escalation of market tensions is highly likely
• Despite having many more tools at its disposal, the ECB may face political constraints on its ability to respond to another crisis

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This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
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