To QE infinity and beyond
Mike Mackenzie’s daily analysis of what’s moving global markets
All eyes were on Frankfurt on Thursday where the European Central Bank delivered an open-ended policy easing that was designed to buy time, via entrenched negative interest rates and a weaker currency, until the eventual arrival of fiscal stimulus. At least that's the idea.
The most telling initial market reaction in the wake of the ECB policy statement (followed by Mario Draghi's press conference) was a sharp rally in bond prices, led by Italy, Greece, Spain and Portugal. Italy's 10-year yield plumbed a record low of 0.75 per cent, before paring a chunk of that drop as the chart below highlights. In contrast, core 10-year yields, led by the German Bunds, reversed earlier declines to rise a touch.
As plenty observed, the ECB has opened the door for “QE to infinity and beyond”, which tilts buyers towards positive-yielding areas of the eurozone bond market. Until inflation returns towards the ECB's target of 2 per cent, QE will roll at a €20bn-per-month pace (from November) rather than end at a stated date.
Andrew Mulliner, portfolio manager at Janus Henderson Investors, noted:
“Given the sclerotic condition of the eurozone economy, this promise to maintain QE until rates go up, is as good as a QE forever. The parallels to Japan are clear.”
Indeed, the ECB lowered its growth forecasts for both 2019 and 2020 (to 1.1 per cent and 1.2 per cent, respectively). The outlook for inflation in 2019 was trimmed to 1.2 per cent, and shaved by 40 basis points to 1.0 per cent in 2020.
The base case for Thursday's meeting was that the ECB would cut rates further into record negative territory, by 10bp to minus 0.50 per cent, introduce a system of tiered charges for bank deposits, so as to alleviate the pain for lenders, outline an extended period of easy monetary policy (dubbed, forward guidance) and resume quantitative easing.
On that score the ECB delivered, but market sentiment always “wants more” as a certain Oliver Twist once pleaded. Some were calling for a 20bp cut and larger monthly purchases of bonds, although the open-ended QE appeared to offset calls for a larger monthly amount.
The market fallout from Thursday's meeting was the usual post-central bank cocktail of choppy trading for bonds and the euro exchange rate, alongside a notable swing in the share prices of financials via the Stoxx Banks index. At the close of play, the leading eurozone share markets were modestly higher, with the Stoxx Europe 600 Utilities sector topping Thursday's leaderboard with a gain of 1.4 per cent. A dividend yield of 4.89 per cent for the sector tells us why.
Andrew Wilson at Goldman Sachs Asset Management summed up the easing package:
“A smaller-than-expected rate cut and a lower-than-anticipated magnitude of monthly asset purchases was somewhat counterbalanced by strengthened forward guidance and the open-ended nature of resumed quantitative easing.”
Short-dated eurozone yields rose sharply, with the two-year bonds for Germany, France, Italy and the Netherlands all up more than 10bp. This reflects the market anticipating that ECB tiering for bank deposits means these institutions buying less short-dated government paper.
That prompted UniCredit to say:
“It remains to be seen whether this is just a knee-jerk reaction, reduced expectations for further rate cuts, or a more fundamental flaw in the tiering framework. The jury is out.”
Longer term, a flatter yield curve does little for bolstering bank profitability. Indeed, the real problem for the ECB remains a failure to clean up the banking sector. The contrast with the US and its banks since 2009 is profound.
The jump in two-year yields also appeared to have stemmed the earlier selling in the euro towards $1.09. By the close of regular European trading, the single currency was pushing beyond $1.1050.
Attention now turns to the policy response from the US Federal Reserve when it meets next week. An expected 25bp cut will barely slice into the hefty interest rate divergence with the eurozone, a disparity that will maintain pressure on the single currency.
One person clearly not happy with the ECB's actions on Thursday was President Donald Trump, who complained via his bully pulpit of Twitter:
Mr Draghi reiterated his previous remarks on policy and the currency:
“We have a mandate. We pursue price stability. And we don’t target exchange rates. Period.”
That said, the risk of US trade action against the eurozone looks high and applying tariffs is one form of currency intervention.
George Saravelos at Deutsche Bank reckons Mr “Draghi's last hurrah” means “we have seen the low in the euro”. He adds:
“The US presidential election, a turn to a more aggressive dollar policy and more Fed easing all make dollar dynamics more negative for next year. But it is too early for that view today, and we believe EUR/USD will remain stuck around 1.10.”
A key to choppy trading market action was Mr Draghi's repeating a plea that fiscal measures are required:
“Now it’s time for fiscal policy to take charge.”
That clearly underlines the limits of monetary policy and highlights the challenge facing Christine Lagarde once she assumes the presidency of the ECB in November.
But as Marc Ostwald at ADM observes, the omens are not good for fiscal stimulus:
“As has already been witnessed at this week's German 2020 budget debate, this call will fall on deaf and intransigent ears, as has been the case since Duisenberg first called for them 20 years ago.”
Still, the calls for big fiscal action won't fade and a deeper contraction (see the latest warning from Germany's Ifo Institute in Quick Hits below) only supports the urgency of deploying fiscal measures, or answering a key question posed by Andrew Mulliner:
“With Christine Lagarde on her way in and Mario Draghi on his way out and a new commission president soon to be in place, the chess pieces are being positioned for such a shift to fiscal. The question we ask is, will they be willing to do whatever it takes?”
That appears to have registered at the margin with some in the eurozone bond market, judging by the back-up in yields from their earlier lows on Thursday.
Quick Hits — What’s on the markets radar
Trade headlines left a mark on Wall Street as Mr Trump indicated he would push back the starting date for higher tariffs on $250bn of Chinese goods to October 15 from the start of that month. Reports the Trump administration had discussed plans for an interim trade deal with Beijing were subsequently hosed down by a senior White House official, but stocks recovered. Among equity factors, there were signs of recovery from the recent “quant quake” as momentum outperformed that of value. All up, it leaves the S&P 500 index nearing its record closing high of 3,025 from July.
The US consumer price index picked up in August with the year-over-year core CPI running at 2.4 per cent, its largest 12-month rise since July of 2018. That helped maintain selling pressure on Treasuries, with the yield on the 10-year note near 1.80 per cent, extending its climb from 1.43 per cent at the start of the month.
Turkey’s central bank delivered a big rate cut and signalled a more cautious approach towards easing, which bolstered the currency. The central bank sliced its main borrowing rate to 16.5 per cent from 19.75 per cent, exceeding market expectations of a 250bp cut. Among major currencies, the lira was Thursday's best performer versus the US dollar, with a further retreat in Turkey's inflation rate the key trend.
Ahead of the ECB meeting, the Ifo Institute cut its German growth forecast for 2019 and 2020, while flagging concern that a contraction in manufacturing threatens the service sector. Ifo forecasts a drop in gross domestic product growth for 2019 from 0.6 per cent to 0.5 per cent and also reduced its estimate for 2020 from 1.7 to 1.2 per cent.
Timo Wollmershäuser, head of forecasts at the Ifo, did not pull any punches:
“The German economy is at risk of falling into recession” and “like an oil slick, the weakness in industry is gradually spreading to other sectors of the economy, such as logistics, one of the service providers.”
Bleak tidings continued as industrial production for the eurozone contracted more than expected in July, spearheaded by Germany, as shown below: