The headlines from last week’s ECB press conference were dominated by the ECB’s €900m increase in Greek ELA, the potential for Greek bonds to be included in ECB QE and the apparent overall commitment to keep Greece in the Euro. But that seems to have allowed more important developments to have pass under the radar: ECB have committed to fighting any unwarranted monetary policy tightening (although judged by 5y5y real rates one has already occurred) and are probably being too optimistic on credit dynamics. Further EUR downside seem likely to result as markets re-focus on the divergent economic prospects and the ECB offsets any impacts of Fed liftoff on EA yields, contingent on the prospective Fed tightening not undermining investor risk appetite.
Fighting a Fed-driven tightening of monetary conditions
The ECB opening statement, which is importantly signed up to by all Governing Council members, included an apparent commitment to “fight the Fed” in terms of the impact of a prospective Fed liftoff on the Eurozone. In particular, it said:
“..we will continue to closely monitor the situation in financial markets…. If any factors were to lead to an unwarranted tightening of monetary policy, or if the outlook for price stability were to materially change, the Governing Council would respond to such a situation by using all the instruments available.”
Draghi and Constancio downplayed the significance by claiming that similar sentences appeared two months ago. But such references aren’t apparent in the previous opening statements and it seems like Draghi has changed tack from his surprising 3 June comment that financial markets should “get used to higher volatility”. That was unsurprisingly interpreted as the ECB being relaxed about the nascent rise in EA bond yields, which opened the way for traders to push yields higher (taking treasury and gilt yields up with them).
Indeed, the higher EA nominal bond yields was accompanied by EA real interest rates rising back into positive territory (see Chart). And in that important sense there has already been a tightening of monetary conditions. And it is notable that the he gap which opened up between EA and US real yields as QE expectations grew and were verified has recently closed (see chart).
Higher real interest rates can in principle be a good news story i.e. if they are reacting to or anticipating better economic news (there is literature on their lead indicator properties). But the speed, timing and circumstances of the EA recent rise (i.e. moving quickly in response to Draghi’s comments) make this less likely now. Indeed, BoE economists think that higher term premia, reflecting international factors affecting bond markets, have been important. And term premia fluctuations are less firmly tied to real-side activity prospects (i.e. they can reflect investors’ risk preferences) than other real rate components. This makes it more likely that the higher real rates are an adverse “shock” to households and firms rather than an endogenous part of the recovery process.
Of course, the main development that the ECB is probably concerned about generating a monetary policy tightening is the prospective Fed tightening. Repeated experience shows that international yield curves strongly co-move, even if recently higher EA yields which have been the main “exogenous” driver. So the ECB will be keen to prevent spillover effects from Fed’s liftoff derailing the nascent EA recovery. In this broad sense the ECB is preparing to “fight the Fed”. That will likely initially be verbally i.e. by stressing that the different economic situation and promising action (trying to manipulate expectations as they did with the OMT) but potentially eventually by expanding its QE purchases should international bond market factors prove too strong.
Draghi optimistic take on lending dynamics
The second notable development was that Draghi talked up the rise in lending to non-financial corporates. But that runs the risk of being overly optimistic.
Sure the annual growth rate of lending to non-financial corporates has continued to recover from the February 2014 trough of -3.2%. But the improvement has pretty glacial (perhaps unexpected given the state of the EA banking sector), an annual growth rate of 0.1% is pretty disappointing big-picture and the recent slowdown in new lending flows (see Chart) undermines prospects of a substantial improvement in the annual rate (base effects will have to be relied upon).
I would place more weight on the change in flows i.e. the “credit impulse”, rather than annual growth rates, as determining whether the EA recovery is set to broaden (as per the ECB forecast). The chart illustrates that there has tended to be a close link between the credit impulse and capex growth (or indeed GDP growth). But it also shows that if anything capex has underperformed, based upon the previous positive innovation in credit flows i.e. credit has disappointed but capex has disappointed even given that disappointing credit. Finally, the supportive credit impulse shows signs of diminishing (the credit flows improvement is slowing).
The bottom line seem to me that we need to start seeing a more substantive improvement in the credit data if we aren’t to start worrying that the EA recovery risks running out of steam. The 27 July data release will be interesting in that respect. Obviously M3 has recently been buoyant, driven by M1, with some analysts linking the latter to upside to industrial production prospects (although it disappointed market expectations last month). But my concern is that the recovery can only be “credit-less” for so long.
This is all important because the nascent EA recovery has, like the earlier recession, been driven by domestic demand. Within that, household consumption has provided most support but capex has also made positive contributions in the past two quarters (although less than implied by the credit impulse). Perhaps initially surprisingly given the euro’s depreciation EA net trade has recently subtracted from growth, after supporting it during the recession. But this illustrates the general finding that relative activity effects tend to dominate exchange rate effects in affecting net trade – as Central Banks like the Bank of Canada are also finding (see my 14 July post).
Draghi also talked up the ECB bank lending survey
Relatedly, the third notable element was that Draghi talked up the evidence in last week’s ECB Bank Lending Survey in the opening statement. But that again seems like stretching things based upon the underlying data.
Specifically, the opening statement noted that “Banks reported a continued net easing of credit standards on loans to enterprises which was stronger than expected in the previous survey round.” While factually correct, that gives an impression of a buoyant picture which is not apparent in the data. I’d point to several less positive credit supply developments: (i) Credit supply was actually less loose than in the previous survey i.e. moved fairly close to the tightening range; (ii) there was only marginal upside news relative to expectations three months ago (within the bounds of survey accuracy?); (iii) credit supply is expected to be even less loose next quarter; (iv) fewer banks expect to participate in future TLTRO operations. So overall I’d judge that the evidence provides no real strong reasons for being optimistic about a substantial improvement in credit availability to fuel the EA recovery.
Draghi also sounded optimistic when he noted that “Net demand for loans to enterprises increased further, supported by demand for credit related to fixed investment”. But he omitted the important points that: (i) the rise in overall loan demand represented only a partial bounceback from a weak previous quarter figure; (ii) once again credit demand was substantially weaker than expected three months ago, thereby continuing the consistent sequence of disappointments over the past three years; (iii) the rise in investment demand also only took it back to where it was two quarters ago; (iv) the other loan “demand” factors (inventories & working capital, M&A and restructuring) have been range-bound in low-positives for several quarters.
To be fair to the ECB opening statement it does note that corporate credit dynamics remains subdued, as “They continue to reflect the lagged relationship with the business cycle, credit risk, credit supply factors, and the ongoing adjustment of financial and non-financial sector balance sheets.” So what is required is a good evidence for why those headwinds are likely to ease, and when.
Corporate profits to the rescue?
And Draghi argued in the Q&A session that the recent oil price fall would support corporate profits (as well as consumption as consumer incomes are supported). And, as an aside, he also argued that the ECB’s policy actions meant that the oil price fall would have wouldn’t again drag down inflation (although it would then surely also support real incomes and consumption less).
EA corporate profits have, however, remained fairly moribund despite the earlier oil price fall. While their nominal value has just exceeded the pre-crisis peak the profit share of GDP remains several percentage points below pre-crisis levels. So firms may well need firmer evidence of the EA recovery taking hold, and substantially easier credit conditions before they start investing. And the EA continues to have the issue of being a disproportionately bank-based system, which is awkward in the wake of a financial crisis (even though the ECB has been leading the way in trying to clear up EA banks’ balance sheets).
Risks skewed to ECB QE extension not tapering, further EUR falls likely
My bottom line from the above is that the risks are skewed to ECB QE being extended beyond September 2016. Of course other factors should be considered (in future blogs!) but (weaker than the ECB expects) credit will be an important determinant of the strength of the EA recovery, particularly given the greater role that banks play in the EA relative to elsewhere. And an ECB committed to offsetting Fed-driven upward pressure on EA bond yields equates to larger EA-US rate divergences and hence greater EURUSD downsides, consistent with the euro’s post-QE funding currency characteristic. EURGBP downsides also look attractive given the more hawkish MPC switch detailed in my 17 July post.
EUR downside may well be reinforced by changing hedging practices and the structural factors of less official reserve demand for euros (it tends to shift slowly but will be gradually undermined by negative interest rates) and net outflows from the eurozone. On the latter, Monday’s data reported further direct and portfolio investment outflows, with the 3-month sums that I prefer to focus on approaching their end-2014 peaks and with the reappearance of net portfolio outflows on that basis representing an optimistic development (see Chart).
But, as I’ve previously discussed, the EUR’s funding currency status means that further EUR falls are also likely to be contingent on the prospective Fed tightening not undermining investor risk appetite. The Fed’s apparent cautious approach, as judged by Yellen’s recent testimony’s keeping the Market guessing between September and December liftoffs, provides some optimism that will be the case. So EURUSD parity by year-end seems plausible in such a “goldilocks” scenario.