What the ECB giveth, the ECB taketh away

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The major event of the week beginning 7 December 2015 was the European Central Bank (ECB) meeting on 10/12/15, which was characterized as a disappointment at best and an abject policy failure at worst. Prior to the meeting, overnight indexed swap (OIS) markets reflected expectations for a 20-basis-point deposit cut at this meeting. Those expectations appear to have been fueled in particular by the news that a ‘two-tier deposit rate’ was one of many options that the ECB staff was considering, an option that ostensibly would allow for a much bigger rate cut compared to a one-tier system. Expectations for aggressive easing were also heightened by inflation misses and ECB President Draghi’s acknowledgement of numerous easing options ahead of the meeting. Thus, markets largely believed an extension of the purchase program, the addition of expanded assets such as corporate bonds, and an increase in the pace of purchases were all likely in some combination at the meeting.

Instead, the Governing Council cut the deposit rate by 10 basis points, left the main refinancing rate unchanged, and extended the duration of the current purchase program by six months. The ECB also expanded the scope of the program to include euro-denominated marketable debt instruments issued by regional and local governments located in the Eurozone, although it was “too early to say” how significant those purchases might prove to be. Finally, the Council announced that it would reinvest the principal payments on the securities purchased under the purchase program as they mature “for as long as necessary”. The lack of any pick-up in the pace of purchases, the failure to clearly commit that the ECB can cut rates further, and perhaps the failure to extend the duration of purchases by more were all a disappointment to market expectations. As a result, the market continued to punish consensus positioning, including short euro and long European fixed income and risk assets. When the terms of the stimulus hit the tape, that positioning revealed itself. The EuroSTOXX 50 fell 4.5%, 10-year German bond yields rose 20 basis points, the euro strengthened 3% versus the US dollar, and asset markets were broadly back to where they were prior to the ECB October meeting.

The fallout of this clear communication error is yet to be determined. The ECB did ease policy further, consistent with their slightly less favorable growth and inflation projections for 2016 and 2017. However, since the October meeting, the ECB fed the market frenzy for the ‘big bazooka package’ and, for the first time, failed to deliver. Now, market participants rightly are questioning the President’s capacity to steer the Council to do whatever it takes to meet its 2% inflation mandate. Going forward, the Board may prefer to talk a little less before policy meetings and to shock a little more on the day. Some believe the market may be less willing to price in policy stimulus before the event next time around, but we would not count on it. Debt loads in the Eurozone remain high, financial conditions have tightened, and accommodative monetary policy is perhaps not sufficient, but certainly necessary to boost inflation and assist the deleveraging process.

Perhaps the ECB was relying on the Federal Open Market Committee (FOMC) to help weaken the euro and boost regional inflation. In addition to a robust November employment report, in her semi-annual testimony before Congress, Chairwoman Yellen indicated that current financial conditions were supportive of a rate hike at the upcoming December FOMC meeting. Specifically, she stated, “on balance, economic and financial information received since our October meeting has been consistent with our expectations of continued improvement in the labor market. And, as I have noted, continuing improvement in the labor market helps strengthen confidence that inflation will move back to our 2% objective over the medium term. When my colleagues and I meet, we will assess all of the available data and their implications for the economic outlook in making our policy decision.”

Exhibit 1: The policy measures announced on 10/12/15 by the European Central Bank fell short of the markets’ expectations and triggered the biggest intraday rally in the euro versus the US dollar since 2009 – the graph below shows the exchange rate EUR/USD exchange rate (the value of one euro in US dollars) during 2015 (from 01/01/15 to 14/12/15).

EUR USD

Source: Bloomberg, December 2015

While the ECB and the FOMC remain key drivers of positioning and expectations, real activity over the next few months and other events this past week remind us that global growth remains in a fragile state. Crude oil closed the week down almost 4% as OPEC failed to stabilize the market with a change to production. Each country will now maintain current production with output likely to increase into 2016. In China, the long-awaited special drawing rights (SDR) inclusion decision finally came and passed with relatively little fanfare. The People’s Bank of China (PBOC) reportedly intervened heavily to maintain the onshore spot Chinese renminbi below the level of ¥6.40/US$. However, late Friday, 4 December 2015, as the intervention reportedly eased, the reaction was an immediate 200-pip rise in the offshore Chinese renminbi from ¥6.43/US$ to ¥6.45/US$, driven by demand for US dollars from corporates and onshore names ahead of the year-end. Developments such as these suggest the disinflationary pressures that motivate the ECB, FOMC, and other central banks may continue for quite some time.

Timothy Johnson

Head of Global Sovereign Fixed Income at FFTW

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