In the past ten weeks or so since the European Central Bank cut interest rates into negative territory and announced a new “TLTRO” liquidity program for banks, the economic data out of the Eurozone has been downright dreadful, showing continued weakness in growth, inflation, and even a deceleration in forward looking survey indicators such as in today’s PMI survey.
This has fueled a considerable amount of speculation in the press and among analysts that ECB President Mario Draghi will announce a readiness to embark on “QE” sovereign bond purchases at this weekend’s Jackson Hole central banker shindig.
*** For all the speculation, we would frankly be stunned if Draghi were in fact to step out in front of his Governing Council to push for a sovereign bond purchase program at Jackson Hole. Phrased differently, we would (gladly) don a pair of Wyoming elk antlers and post it on YouTube were he to do so. ***
*** QE – and by “QE” we mean sovereign bond as opposed to the more modest Asset Backed Security purchases – is a real, and not just hypothetical, option in the ECB’s tool kit. And despite a great deal of market skepticism that the ECB could ever actually gather real consensus to embark on QE, we were early to note the work the ECB Executive Board was putting into building an internal consensus for this policy option if needed (see SGH 2/28/14, “ECB: Signaling the QE Option”). The question for QE, beyond the notion of an ECB President announcing a major policy shift at a Kansas City Fed Conference, is rather one of timing, effectiveness, and whether it is in fact an appropriate policy step at this juncture. ***
*** We DO expect Draghi to emphasize at Jackson Hole that the ECB will do “what it takes” to turn inflation around and leave its options open, which would include QE. But we believe a large portion of his discussion on labor market dynamics – which after all is the subject of the weekend – will also revolve around supply as well as demand constraints on European labor markets, and beyond what the ECB can do, the need for structural and labor market reform, a sound fiscal policy, and pro-growth fiscal policies focused on lowering taxes and spending and not just higher taxation in balancing budgets (a long list for sure, which is another way of saying monetary policy cannot achieve everything). ***
*** We also fully expect Draghi to re-emphasize – either in prepared remarks or on the sidelines of the conference – the diverging economic and monetary policy cycles between the Eurozone and US. As the Fed gets closer to its long awaited lift-off date, that divergence will continue to be emphasized by ECB officials, both to lock in and anchor the ECB’s forward guidance and rate expectations, and to clearly keep the downward pressure on the Euro. ***
We believe ECB officials will for now focus on existing initiatives (ABS and Stress Test) and seek to look through some of the latest weak data points for a cleaner medium term picture to assess the impact of recent geopolitical volatility, as well as to allow for some lag effect for the already extremely accommodative conditions taking hold.
Fifty Shades of Weak
Since the ECB cut rates in June, the Euro has dropped 4 cents (7 from the previous month), ten year German bund yields have plunged from 1.4% to below 1%, and Italian ten year yields have dropped from 3% to 2.6%. Shorter term rate expectations have also rallied massively – December 2017 Euribor for example has posted a 45 basis point yield compression since the June meeting and rallied over 75 basis points since May, despite market assertions at the time that everything was already “all priced in,” (we did not agree – see SGH 6/4/2014, “ECB: A Deeply Complacent Market”).
Those huge moves are clearly not just a result of the ECB’s forward guidance on rates, but reflect as well a series of data releases that has only reinforced the continued weakness in the Eurozone economy.
That it is only now that market participants are starting to take the prospect of sovereign bond purchases seriously — and even then only roughly half of market participant believe it possible — we think is in itself significant: it indicates that much of the rally was not in fact in anticipation of future QE, but a reflection of existing weak fundamentals and ultra-loose monetary policy.
Clearly a bond purchase program would help drive yields lower yet, but it still appears too early and far too soon after the June easing measures to undertake such a dramatic and still controversial “break the glass” option when the transmission of the June measures are still working their way into the economy. Monetary policy, after all, does operate with a lag.
Beyond the Jackson Hole meeting, markets will be focused on the upcoming ECB Governing Council meeting on September 4, especially as it will also include the latest quarterly Eurosystem Staff Macroeconomic Projections.
In light of the string of weak data points – including the horrendous 0.4% annualized June CPI print and a flat second quarter Eurozone GDP – between June and then, there is no doubt these forecasts will have to be revised down yet again from already very weak levels. But we suspect that the ECB revisions may not be as dramatic as, for example, the widely followed Survey of Professional Forecasters revisions just released on August 11.
And that is because the ECB numbers were already lower than the SPF’s – last week’s SPF inflation revisions in fact just put them in line with the ECB’s June forecast.
The SPF put 2014, 2015 and 2016 inflation respectively at 0.7%, 1.2% and 1.5%, versus 0.7%, 1.1% and 1.4% for the June ECB staff projections, and 1%, 1.5%, and 1.7% on growth vs 1%, 1.7%, and 1.8% for the ECB. That indicates perhaps a higher likelihood if anything of a downwards ECB staff revision in growth than a material revision down in the already ultra-low inflation forecast – at least for now.
Furthermore, the recent data will to no small extent have been impacted by geopolitical tensions on top of an already fragile economy. The ECB will need to get a better sense of how transitory and how deep the impact is of not just headline tensions on confidence but the recently announced sanctions.
Finally, the ECB will want to assess the impact of the extra accommodation already flowing into the economy, albeit stilted through a still impaired transmission mechanism.
At the July monthly Governing Council meeting Draghi promised to deliver some news on the ECB’s efforts to stimulate the ABS markets, as painfully boring and frustrating as that has proven to be. Those efforts continue to revolve around establishing a higher tier ABS market that can be securitized more easily and collateralized with modest haircuts, presumably on the balance sheet of the ECB.
Finally the first tranche of the new four year TLTRO (Targeted Long-Term Refinancing Operation) will only be allocated on September 18, after next month’s meeting, with the second tranche not until December 11.
We do not ascribe to the theory pushed in some quarters after the June rate cuts that the ECB had “made a deal” with hawks not to do anything until at least after December – and we do believe that by the fall and end of the year, if there is no stabilization and recovery in the data, the ECB will need to start considering additional measures.
We do not, however, believe that openness translates into the sort of impatience that would be implied in jumping the gun so soon after the June measures, and even before the first TLTRO, on opening the door to bond purchases. At least not yet.