With a week having passed since the ECB’s surprising “hawkish ease” it’s useful to take stock of what it all means for ECB monetary policy, the EA economy and financial markets. And how this fits into an environment featuring an oil price collapse (and commodity weakness more generally) together with anticipation of the likely 16 December Fed hike. Here’s how I see it all adding up (the charts below spell things out in more detail):
• The ECB has overseen an unhelpful tightening of EA financial conditions: EUR appreciation, higher EA yields (particularly real interest rates) and greater falls in EA equities than elsewhere. The EUR spike was especially pronounced (second-largest on record, driven by the unwind of short positions I discussed here), exceeded that implied by revisions to policy expectations, and been more persistent than the rise in yields (which have retraced a little). That’s not great for growth and inflation prospects.
• The bar for further ECB action has been raised as the approach has apparently moved away from taking out insurance against potential downside inflation risks. Unfortunately that’s happening just when those risks seem to be growing: the ECB staff forecast argues that “The depreciation of the euro, upward oil price-related base effects, and the assumed increases in commodity prices are expected to be among the main drivers of the pick-up in inflation over the projection horizon” yet all those inflation supports seem in jeopardy. And a policy judged merely as “adequate” is very different from Draghi’s November 20th pledge to “do what we must to raise inflation as quickly as possible” and Praet’s concerns about inflation expectations.
• The ECB will therefore likely be nervously watching fragile EA inflation breakevens and EUR strength given the oil price collapse (the oil-beakevens link, which lessened on hopes that ECB would act decisively to address the EA’s lowflation problem, could reassert itself), potential for greater risk aversion (which would see EUR-funded carry trades unwind and support EUR, with equity price falls also reducing hedging needs) and likely dovish Fed hike (risking supporting EUR near-term).
• So the risks are skewed to ECB eventually easing further in 2016, with a deterioration of inflation dynamics driven by further oil prices and less EUR downsides the most likely triggers. But it’s also notable that the ECB inflation forecast would have been up to 0.2pp lower, potentially provoking more aggressive action, if ECB staff hadn’t cut their productivity forecast (with no explanation, which in turn raises unit labour costs and domestic inflation pressures). But, to re-iterate, the bar remains higher than previously despite Draghi arguing that there are “no limits” to ECB balance sheet expansion.
• Draghi’s underestimation of the ECB hawks, and consequent credibility hit, means he’ll likely find it more difficult to influence markets via verbal interventions. That could be a potential (unecessary) hindrance in coming months.
• The ECB may be being too optimistic on loan dynamics, and hence investment prospects. Draghi’s right that corporate lending rates have fallen (equivalent to a 100bp rate cut according to the staff) but that was from pretty elevated levels and cross-country divergences persist. And actual corporate lending hasn’t picked up much (indeed credit is contracting in many members), I think that they’re over-egging the Bank Lending Survey and recent capex dynamics aren’t great in most members. So there remain questions about the breadth of the recovery (which ECB anticipate being largely consumption-based, despite persistently-high unemployment and weak wage growth).
• The ECB has made the Fed’s job on 16 December a little easier by ameliorating some of the USD upside that could have constrained a hike. That said, the oil price collapse has seen USD strengthen considerably against commodity FX. For example, USDCAD has hit multi-year highs, with the expected policy divergence theme remaining apparent in recent weeks (BoC’s Poloz signalled on Wednesday that he was OK with CAD weakness).
• But the Fed seems unlikely to immediately stoke the policy divergence theme (as a driver for FX movements), despite being odds-on to hike by 25bp next week, given the considerable effort expended to generate expectations of a “dovish hike” and their general concerns about USD strength. Their recent communications have stressed on how the “neutral” interest rate has fallen. And unlike the ECB, they have no incentive to renege on their communication by surprising hawkishly next week: they don’t want to stoke a US treasury sell-off or a further leg of USD strength. While payrolls are going great guns, it shouldn’t be forgotten that wage growth has yet to really pick up and core inflation measures continue to underperform (FOMC continue to rely on the Phillips curve kicking in with a lag, I’d personally be a bit more cautious). Moreover, a little-appreciated fact is that US inflation breakevens have actually been more closely correlated with oil prices than have EA breakevens. And US manufacturing and exports have continued to be adversely affected by the USD strength. So the bottom line is that there remain ample reasons for the Fed remaining cautious in its lift-off, continuing to stress that the pace of rate rises will be gradual.
• Moreover, a Fed rate hike is now virtually completely priced in by markets – suggesting only limited room for a knee-jerk US Treasury sell-off and hence USD support on the decision. And I suspect that the Fed will achieve its dovish message via the dot plot shifting down (closer to dovish market expectations) and possible downward revisions to the inflation forecasts, together with dovish press conference comments. And this will likely be more impactful on the day than the rate hike, in my opinion. Hence the near-term risks seem skewed towards limited treasury rallies and hence limited USD retracement, with further limited EURUSD upside potentially worrying ECB. The moves seem likely to be limited because such Fed dovishness should also already be at least partly factored into market expectations, although they could still be amplified by positioning adjusments.
• But I’ve also previously argued that there are reasons to think that previous (superficial) buy the rumour sell the fact dynamics around previous Fed rate hikes won’t necessarily apply this time around. For example, the 2004 experience reflected USD being a funding currency and oil price rises deteriorating the US current account: a very different scenario to now. And the USD support from continued rises in US yields after Fed hiks has often been offset by growing expectations of non-US rate hikes, which again seems unlikely with the ECB and many other central banks in easing mode (the BoE is the main, protesting, exception). So I don’t anticipate a major US treasury rally or USD sell-off.
• Ratther, overall EURUSD seems likely to remain rangebound (probably 1.05-1.12) in the near term: short EUR positions will again start to look attractive towards the top of that range and dovish ECB rhetoric could again yet resurface with any further substanive EUR upside (subject to the “won’t be fooled again” issue discussed above).
• And oil/commodity price weakness may well be a stronger driver of FX volatility over the next few weeks than policy divergences. USDCAD upside may consequently have further to run, especially with the BoC not resisting CAD weakness in response to the terms of trade shock. But EM commodity producers and EMs with external dollar-denominated funding requirements also seem vulnerable.
• The policy divergence theme could well, however, strengthen again in the next few months as the US recovery gathers pace (and wages/inflation start rising more substantially) and if my scepticism about EA growth and inflation dynamics proves correct, bringing ECB reluctatly back to the table (although prospective base-effect driven rises in headline EA inflation militate against this) and/or if the oil price continues falling.
• And we shouldn’t forget that the ECB deposit rate cut further into negative territory, while disappointing, increases the incentives for funds to flow out of EA assets abroad seeking higher (non-negative!) returns. Such longer-term factors may well gain further traction over the coming months as FX traders get over last week’s disappointment (despite the growing EA current account surplus, but subject to investigation of relative equity valuations).
ECB has overseen a tightening of EA financial conditions (although some has retraced):
ECB will be nervously watching (fragile) inflation breakevens and EUR strength:
ECB could be too optimistic on credit dynamics and capex prospects:
USD recently supported against commodity FX, policy divergence theme apparent
Strong incentives for the Fed to Proceed cautiously (as signalled): Dot Plot will be key