Today’s headlines have been dominated by the 9-0 MPC decision (which I correctly anticipated, together with the EURGBP rise, see here). But financial market developments over the past couple of days have also made for some very uncomfortable reading for the ECB – financial conditions have once again tightened despite Draghi’s strong hints at further ECB action in March (see my preview of the January ECB meeting here).
Indeed EA financial conditions are back where they were before the ECB announced QE in January 2015, raising questions about its efficacy. Draghi rightly points out that the real-economy counterfactual would likely have been much worse and the fresh China/EM/oil price shock is out of their control. But nevertheless the financial market developmets will make uncomfortable reading given the fragile state of the EA recovery – such a tightening of financial conditions is precisely what the doctor didn’t order. And they testify the battle that Draghi faces in convincing a sceptical market that he’ll be able to overcome resistance within the Governing Council to actually deliver further easing in March: I discussed here how one of the side-effects of disappointing in December was that Draghi could well have less leverage over financial markets (“won’t be fooled again”). Nowotny’s recent comment that he hoped that financial markets would be “more rational” than they were in December isn’t particularly helpful (you get what you asked for….).
First, the EUR TWI has risen to the highest level since 14 January 2015, when Draghi pre-empted the 22 January ECB QE announcement by stating “All members of the Governing Council of the ECB are determined to fulfill our mandate”. Of course, the EUR strength has been importantly driven by the USD weakness in the wake of this week’s disappointing US ISM data (EURUSD has risen sharply to around 1.12, EURGBP also rose today on the 9-0 MPC vote). While the ECB has stressed that the EUR isn’t a policy target it’s nevertheless made clear that EUR strength leads to subsequent inflation weakness. And given the difficulty that the ECB’s been having getting EA inflation to show any significant signs of life (with oil-related base effects now unikely to help out, see here) the ECB’s apparent loss of the latest skirmish in the currency war isn’t helpful in achieving their inflation objective.
Alongside this, EA 5y5y inflation breakevens have fallen to around 1.50% (1.493% yesterday) very close to the 1.48% low-point of 14 Jan 2015. And the worring thing for the ECB is that the latest leg down has occurred despite oil prices bouncing (on market hopes of a Russia-OPEC supply restraint deal). Of course breakevens’ movements can be driven by risk/liquidity premia, and its notable that the latest falls are strongly correlated with falls in Eurozone equites suggesting a link to market risk appetite. But the decline in EA breakevens is more of a straight-line fall than for UK breakevens, suggesting something specific to the EA. And with EA inflation not really showing any signs of life it’s not surprising that markets could well be challenging ECB credibility. And it’s notable that many of Draghi’s recent exhortations have mentioned credibility.
Of course, the latest fall back Eurozone equity prices, from their bounce last week, is worrying in its own right: it will hit household wealth and raise corporate financing costs. Indeed, the DAX and €stoxx are 4.9% and 9.5% below their 14 January 2015 levels (and 10.5% and 13.1% below their levels when Draghi announced QE on 22 January). Of course, there’s again a global element to equities’ weakness (risk off and all that). But its again notable that EA equities have actually fallen significantly more than US or UK ones. The travails of some European banks obviously isn’t helping (and reduces optimism about their willingness/abilty to lend, see below).
Some limited comfort can be taken, however, from the continued falls in EA nominal bond yields – they mean that EA real interest rates haven’t risen markedly despite the aforementioned continued declines in EA inflation breakevens. Specifically, 2 year bund yields have hit fresh historical lows of around -0.5% while 10 year bund yields now aren’t that far above the levels prior to Draghi’s infamous “get used to volatility” comment which so riled bond markets last April. But it’s hard to tell a convincing story of that representing the beneficial imacts of ECB QE rather than part of a global trend: Bund yields are down by less than Treasury yields since since December and start-2016. Its only over the past fortnight that bunds have fallen by more.
EA yield curve to flatten as ECB QE elibility contraints (scarcity) bind more tightly
But an important implication of the continued EA government bonds rally is that an increasing proportion of short-end bonds now yield less than the ECB’s -0.3% deposit rate and hence are inelibible for ECB QE purchases. Press reports indicate that a quarter to a thirds of EA bonds now suffer from this elibility constraint, with even 5 year bunds now close to the hreshold (latest -0.24%) while 3 year OATs (France) and even Irish 2 year bonds are below it. So more of the ECB’s €60bn a month QE purchases will be forced to find its way into longer maturity bonds (although cutting the deposit rate further would in itself loosen the constraint a little), putting further downward pressure on medium/long yields. As such EA yield curve flatteners (e.g. 5s10s) may be attractive, despite some limited flattening thus far (10s30s seem less likely to be impacted).
Of course an alternative strategy could be for the ECB to start buying riskier bonds, building on the December extension of purchases to regional and municipal bonds to relieve eligibility constraints (when Draghi commented that it was “too early to tell extent of municipal purchases“). But I suspect this would meet significant resistance within the ECB: the latest Accounts showed that the hawks were worried anout adverse side effects but were more relaxed considering further deposit rate cuts (see here).
Periphery becomming an issue again?
And a further potential worry is that the political/fiscal uncertainties in Portugal, with the European Commission asking the new government to re-submit budget plans by tomorrow, have started to outweigh the cossetting effects of ECB QE on Portuguese bond yields (see my post from October on Portugal’s structural issues). Specifically the 10 year PGB-Bund spread has risen to it’s widest since early-2014. Moreover, the QE prop risks being taken away: only countries rated as investment grade are eligible for ECB purchases and only one ratings agency (DBRS) judges Portuguese government debt to be investment grade. Moreover, DBRS is shortly going to be reviewing the Portuguese situation and a downgrade, to rating more in line with the other agencies, then the ECB would face a real dilemma (could it grant some form of exemption despite likely protests from the hawks) and the Portuguese bond sell-off would likely accelerate.
Thus far the rises in Spanish and Italian spreads have been limited. But the on-going uncertain Spanish political situation – Socialist party leader Sanchez may find it hard to form a government after bign given the mandate by the King, a fresh election may well be preferable to Podemos being part of a government – means this might not last. And obviously political uncertainties make it less likely that governments will heed the ECB’s exhortions to play their part in the recovery by pushing ahead with structural reforms (the economist persuasively argues that France has one last chance of reforming it’s labour markets).
Political resistance to ECB policy
But some of the politicians actually look to be pushing back against ECB policy. Specifically, I was pretty aghast at some of the comments recently ascribed to German politicians “I will not deny that the low interest rates are worrying us…and I hope therefore that this will change. I believe Mr. Draghi knows that we’re waiting for this.” (see this bloomberg report), even if there are genuine concerns about German banks’ profitability. So much for the traditional German belief in Central Bank independence, or indeed of the monetary-fiscal authorities engaging constructively for the best outcome. Draghi’s speech today at the Bundesbank had a strong theme of “no surrender” in the face of low inflation and the dangers of a wait and see approach: it could certainly be read as “no surrender” to the more hawkish views within the ECB (see below).
The real economy isn’t turning
All the above would be less worrying if there were genuine signs of the ECB stimulus thus far causing the Eurozone economy to transition to a better growth trajectory. One of my previous posts, to be fair detailed some reaons for limited optimism. But recent important economic news has been negative. This weeks’ latest round of EA PMIs were pretty underwhelming – stalling headline figures with slowing activity, new orders and employment components and the intenfification of deflationary pressures reported by Marki (see here). Add to this Germany’s relatively-large trade exposure to China seeming to bite, with IFO export expectations falling sharply and the general expectations component slipping back. And lending to non-financial corporations again disappointed by slipping back to a measly 0.3% y/y in December, reducing hopes of an investment recovery (even if there is some survey evidence of better investment intentions, see here).
ECB easing is urgently needed (probably more than 10bp) but ECB appears divided
The bottom line is that the need for further ECB looks increasingly pressing, especially with Draghi stressing that second round effects of low inflation feeding through into inflation expectations and wages. But thus far markets have been sceptical about Draghi’s ability to overcome GC reservations and actually deliver on his rhetoric – probably rightly given December’s events.
At the 21 January ECB press conference Draghi stressed that the Governing Council unanimously backed the headline statement that “It will therefore be necessary to review and possibly reconsider our monetary policy stance at our next meeting in early March“. But that language is a bit weaker than that preceding previous ECB actions. And Weidmann subsequently reiterated that the ECB should look through the short-term, oil-price driven fluctuations in inflation while his Bundesbank colleague Nagel awaits the lagged effects of previous ECB actions. That said Weidmann actually isn’t voting in March, which raises the chances of action. But even GC members like Yves Mersch have been trying to talk down easing expectations “we might see the necessity for technical corrections to our existing program“.
But given that a 10bp deposit rate cut is already more than fully-priced, the ECB will have to go further to impact the market – which is anyway also sceptical about the efficacy of further QE given how low (core) bond yields already are. The ECB might need a bazooka to get inflation breakevens back up, which seems increasingly unlikely give the apparent GC disagreements. And the danger is that tightening of financial conditions that’s occurring right now could well have adverse economic impacts that prove difficult to reverse even if they do act in March (e.g. inflation expectations fall further, low wages get ingrained, the long hoped for investment recover gets permanently postponed due to weak demand conditons). Such dangers could probably have been avoided if Draghi had managed to convince the hawks of the need for strong action in December. So the next few weeks will likely have a significant bearing on ECB credibility. Financial markets will be watching carefully.