ECB need to start to recognising “an unwarranted tightening of monetary policy”

A range of financial market developments suggest that the ECB should be getting more concerned that “an unwarranted tightening of monetary policy” is occurring. The euro TWI is up nearly 5% (due to risk aversion effects, looking likely to knock ¼pp off the ECB’s inflation forecast), EA real interest rates have risen sharply (more than US equivalents), the EA yield curve is steeper than before QE and EA equity prices have fallen sharply. I also noted here that the euro area is relatively exposed to a broader slowdown in AxJ demand (accounting for around 30% of EA goods exports).  ECB Chief Economist Peter Praet’s comments this morning suggest that the ECB could well be moving in the direction of recognising those risks next week (although Vice President Constancio seemed less convinced yesterday). So I suspect that a dovish ECB press conference, with the inflation forecasts nudged down (or greater downside risks installed) and dovish language including some mild EUR jawboing could see EUR fall a little (probably not a lot). Much will depend on the general risk environment (hello PBOC!) and the US data/Fed policy flow. And there may well be little that the ECB can do about the EUR’s strong link with risk appetite, although a dovish press conference would help support risk appetite (as long as forecast downgrades don’t spook markets).

Tightening Financial Conditions

My previous post detailed how the ECB’s July introductory statement suggested that the ECB stood ready to act if the situation deteriorated: “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 within its mandate.” And it appears that a range of financial market developments represent a de facto tightening of financial market conditions – via the euro appreciating (with risk aversion effects, looking likely to knock ¼pp off the ECB’s inflation forecast), EA real interest rates rising (more than US real rates), the EA yield curve being steeper than before QE started and EA equity prices falling – summarised in the charts below.

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I’ve previously discussed how the euro has recently been supported by risk aversion effects as its funding currency induced weakness reversed. Much market attention has (understandably) focussed on EURUSD – which went through a rollercoaster ride this week as it rose sharply to above 1.17 as China uncertainties caused EUR-funded carry trades to unwind before again falling back down below 1.14 today as risk appetite returned following yesterday’s PBOC 25bp rate cut and 50bp RRR reduction alongside liquidity injections. Atlanta Fed’s Lockhart refraining from throwing further fuel on the fire, by seemingly toning down his previous stance of there being a strong case for a September rate hike also helped calm nerves. And today’s dovish comments by ECB Chief Economist Peter Praet also provided a little extra impetus to unwind of near-term EUR strength (see below).

But the EUR TWI, which the ECB pays more attention to, has come back down less. And even at today’s close, after risk aversion has stabilised and Praet has been dovish, the EUR TWI lies 4.8% above its mid-July lowpoint and has moved back above its pre-QE level. This is important because, according to the ECB model’s multipliers, a 10% EUR TWI rise knocks 0.5pp off inflation 1-2 years later. So the euro’s TWI rise since mid-July i.e. around the previous ECB press conference, will on its own reduce the ECB’s inflation forecast by around ¼pp i.e. a fairly chunky impact, if ECB staff apply the standard multipliers when they update their June forecasts (the EUR TWI since then is similar).

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Moreover, should risk aversion remain elevated for a more protracted period a further (stronger?) stage of EUR upside could potentially arise from the repatriation of the (gross) portfolio outflows from the Eurozone (EA investors buying foreign assets) over the past couple of years. Such outflows, which have been the hope of longer-term EUR bears but which have often been matched by foreign purchases of EA assets, have been largely into foreign long-term debt which may make them relatively sticky in the near-term. Such repatriation flows are often used to rationalise the Yen’s safe-haven nature, although Japanese investors have a larger stock of foreign assets to repatriate.

I’ve also majored on the continued fall in euro area inflation breakevens which has accompanied the recent renewed oil price plunges. While US breakevens have also fallen in recent weeks (although interestingly UK ones haven’t) the ECB have previously paid them substantially more attention: they were an important ingredient in the gradual/eventual move to negative interest rates and QE. Of course, you can argue that the ECB may have made a rod for its own back given that breakevens contain a lot more things than actual inflation expectations (and I noted here how Fed staff think that inflation risk premia account for the US fall). Neverthless the fall is worrying for the ECB in two respects.

First, it implies that market participants do not believe that he ECB will achieve their target, even far out: 5y5y breakevens around 1.6% likely can’t be consistent with the “close to but below 2%” objective, given that they contain term premia compensation (i.e. underlying market-derived inflation expectation are below 1.6%). And the fact that EA 5y5y breakevens are now below where they were when the ECB started QE in January, and they were falling in the run up to it starting, suggests that ECB credibility has been slowly ebbing away.

Second, for a given nominal yield lower breakevens equates to higher real interest rates. And it’s worse than that because EA nominal yields are also on balance higher than when QE started, with Draghi’s comment at the June ECB press conference that markets should “get used to higher volatility” representing an important spur. So EA 5y5y real interest rates have risen by over 100bp since mid-April and are 60bp above their January QE levels. The bottom line is that all of the decline in real interest rates which preceded the start of QE, and which seemed like a useful support for EA activity, have unwound.

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In November 2014 Draghi spelt out the danger of this dynamic generating an effective monetary policy tightening. “…if inflation expectations fall, the real interest rate rises, which is the interest rate that matters most for investment decisions. And because nominal short-term rates in the euro area have already reached the effective lower bound, they cannot be adjusted downwards further to compensate for this. In other words, any de-anchoring of expectations would cause an effective monetary tightening – the exact opposite of what we want to see.”

The further worrying thing is that EA 5y5y real interest rates have actually risen twice as much as US real interest rates since mid-April (over 100bp versus around 50bp) and four times the rise UK real interest rates. I’m dubious about whether the fragile EA recovery can handle such a de facto monetary tightening (many commentators are not convinced that even the US economy is quite ready for tighter monetary/financial conditions, never mind the fragile Eurozone).

A further angle is that since the inception of QE the ECB have seen policy acting by flattening the yield curve. In particular, Benoit Coeure argued in May that “An inability to cut short-term interest rates does not therefore make monetary policy ineffective if the tools are available to influence the shape of the yield curve. At one extreme, one coud argue that the true lower bound for monetary policy is reached only when the entire yield curve is flat at the effective lower bound”. And once again things are less optimistic than before the start of QE: the EA yield curve is significantly steeper than in January, suggesting less monetary stimulus. This time, however, most of the change happened a couple of months ago and there has only been a small steepening more recently (although the US yield curve has shown more signs of flattening over this period). And the interpretation is more ambiguous since there is a literature (Estrella and Mishkin (1996)) that a more upward sloping yield curve predicts stronger future growth. But it is nevertheless notable that the ECB have gone quiet on their view on the slope of the yield curve: some clarification would be useful.

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Finally, Eurozone equity prices have declined quite sharply, implying negative wealth effects for households and higher funding costs for corporates, especially in recent days with the Chinese worries. Indeed, I’ve previously noted that Eurozone equities have been negatively correlated with the euro – illustrating the importance of risk aversion/funding currency elements in the euro’s movements. Equity prices have obviously fallen globally, although the €stoxx falls are amongst the largest.

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Praet’s comments suggest 3 September ECB meeting could be more interesting

ECB Chief Economist Peter Praet today seemed to open the door to a dovish ECB press conference next week. In particular, he noted that “Recent developments in the world economy and in commodity markets have increased the downside risk of achieving the sustainable inflation path toward 2 percent”. He also conveniently mentioned that the forecasts which ECB staff are currently updating “will serve as the basis of discussion” and reiterated that “There should be no ambiguity on the willingness and ability of the governing council to act if needed” and that the APP “provides sufficient flexibility to do so in terms of size, composition and length of the programme“. In terms of recent market movements he argued that “We have to take some distance from the short-term volatility of the market…from the monetary-policy perspective, we will have to think about the consequences in the pricing of risk.”

Despite those hints I’m not really expecting the ECB APP to be tweaked at next week’s ECB meeting. Rather, the action is most likely to be in the updated forecasts and language tweaks. There’s certainly a case for shaving the central inflation forecast to be less rosy (see above). But I suspect that they could well instead end up making the negative inflation forecast skews larger and adopting more dovish language in the opening statement and press conference. The latter could well (should!) include some mild jawboning on the EUR, such as reminding markets about the inflation multipliers discussed above, although as I previously argued I suspect that their trigger level is a closer to 1.20 (or above) than to current levels. You live in hope that they act more aggressively. And they may need to be aware that the EUR upside dynamics could strengthen if portfolio asset repatriation starts kicking in with more persistent risk aversion.

But at the end of the day there may well be little that they can do about the EUR’s strong link with risk appetite – it was their negative interest rate policy which turned EUR into a funding currency to start with (talk about potential unintended consequences!). So their best hope to avoiding further near-term EUR strength may be to try and support risk appetite (and hope that China and/or the Fed don’t spoil the party). So while my overall bias is for EUR to weaken into a dovish press conference I’m not anticipating large moves unless the ECB pulls a major surprise and extends QE.

And, importantly, ECB Vice President Constancio’s appeared considerably less dovish yesterday. While he maintained the ECB’s long held stance that it stands ready to use “all the instruments available within its mandate” he said that he was confident that full implementation of APP would lead to a sustained return of inflation back to target “underpinning the firm anchoring of medium to long-term inflation expectations”. And, even though he acknowledged that the fall in EA inflation breakevens reflected renewed oil price falls he argued that wasn’t in itself a cause for further ECB action. His argument that “Monetary policy cannot and should not try to correct, because those effects will disappear one day…the price of oil will not go down to zero” seems OK when talking about about spot inflation but not really about declining inflation breakevens (standing pat and letting them fall sharply is dangerous for credibility) unless you’ve got strong (model based) reasons to believe that market inflation expectations aren’t ebbing. Moreover, unlike Praet, Constancio downplayed recent China-induced volatility “Markets are now correcting the initial overreaction….the economy is not decelerating so much to justify the rout in the stock market…the stock market was perhaps too buoyant” and argued that the yuan devaluation is “not a major factor” for the euro-area inflation outlook.

There could also be resistance from the Bundesbank to too dovish a shift, given their apparent reluctance to acquiesce to QE. Yesterday’s German GDP data confirmed the somewhat disappointing flash 0.4% Q2 figure (see here). But it was notable that, as previewed by the FSO on 14 August, the growth was more than accounted for by net exports – investment was weak and consumption was pretty muted. And that relatively strong net export performance would likely face challenges should China slow more sharply (as I suspect that it may, given the relative weakness of freight shipments and electricity consumption – see here). So while yesterday’s German IFO survey surprised slightly to the upside, with there being no apparent adverse impact from China worries (although the expectations component was notably weaker than the current conditions) my bias is for this to become more apparent in the coming months given the lags involved (and the IFO survey questionnaires were sent out 3-5 August i.e. before the latest China worries surfaced).

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So there could well be a very interesting exchange of views within the ECB before the press conference. We could get some idea of Benoit Couere’s views when he speaks on Thursday. But the tone could of the debate could also be affected by Thursday’s ECB money and credit data, where the focus will be on whether there are any signs of the ECB’s relatively rosy view on lending dynamics showing up.

Overall, I suspect that a dovish ECB press conference, with the inflation forecasts nudged down (or greater downside risks installed) and dovish language including some mild EUR jawboing could see EUR fall a little (probably not a lot): with EURUSD down a big figure if we’re very lucky (much of it may already be priced after Praet’s comments), a little more if there is a strong hint at QE extension.  But much will depend on the general risk environment (hello PBOC!) and the US data/Fed policy flow, although I haven’t got big expectations for strong reactions to Thursday’s US GDP update (the market is already pricing an upward revision, with today’s strong durable goods helping sentiment), Friday’s core PCE deflator release (probably more of the same limited inflation pressures picture) or Stanley Fischer’s Jackson Hole appearance on Saturday.

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