Un travail inachevé

ECB: the time of the big decision is still to come

The ECB announcements last week seem to have left the market quite quizzical. On the face of it, the central bank delivered what the market was hoping and beyond, with an “open-ended” quantitative easing (QE) offsetting a low quantum of monthly purchases (EUR 20bn per month) and a lower-than-priced deposit rate cut (10 bps), with some nice news for the banking system coming on top (“tiering” and a more generous long term injection of liquidity). It is thus somewhat surprising that financial conditions by the end of the week, at least for the core countries, were actually tighter than before the ECB announcements. The German 10 year Bund closed at -0.45%, up by 10 basis points. Three-month money market rates were 3 bps higher and the euro was slightly higher relative to the dollar. The only clear beneficiary seemed to be the Italian sovereign, as its spread relative to Germany fell from Wednesday.

A positive reading of these developments would be that investors were convinced by the ECB ‘s renewed commitment to do – once again – whatever it takes to bring inflation back to target. Incidentally, forward inflation swaps moved in the right direction after Draghi’s announcements. In a more pessimistic reading, the market reaction would merely reflect doubts on the actual strength of the central bank’s commitment. We find it interesting that on Thursday German yields started rebounding at the moment Mario Draghi, during the press conference, refused to say whether the ECB’s purchasing limits had moved – simply stating the Council had “no appetite” to discuss this at this stage. Indeed, we think this is key.

In our Macrocast last week we argued that “ a potentially time-unlimited commitment to buying (…)cannot be achieved in a convincing way without disposing of the 33% holding limit on sovereign bonds”. The ECB has told us they would buy until shortly before starting to hike the policy rates, a move which itself is now dependent on a “robust convergence” to their target, which will need to be “consistently reflected” in underlying inflation dynamics. This may well take some time, according to the ECB’s own forecasts (they see core inflation at 1.2% only next year). Without removing the limits, the ECB could be “stopped out” before delivering on its commitment.

The ECB has some time. The monthly quantum is low, and the ECB has taken the precaution to be able, from now on, to buy private assets with yields below the deposit rate, which we take as a way to create some additional room to skew the programme towards a smaller share of sovereign bonds. The issue of the “limits” may thus not become pressing before next summer. But this could mean that the “big decision” will need to be made by the next team, under Christine Lagarde. And this is where the current division in the council matters most.

Based on their own statements or press reports, it seems the Governors of the national central banks of Germany, France, the Netherlands and Austria opposed the resumption of quantitative easing. That makes 55% of the capital of the ECB subscribed by the Euro area member states. Obviously, the ECB does not operate like a public company. The Governors of each national central banks are supposed to make their decisions by taking into account the situation of the entire Euro area, and not act as representatives of their country. The Governing Council is driven by a “one member - one vote” principle, and the NCBs’ voting rights rotate even if they all are present at the Council meeting  (Banque de France for instance could not vote last week). Still, the “optics are not great”. That is actually probably one of the reasons why Mario Draghi stated that the decision was made without taking a formal vote. The hawks probably knew they could not command a majority anyway, and not taking a vote was probably collectively the best way to minimise the communication damage.

A key issue now is how the next team in Frankfurt will work. For his last momentous decision, Mario Draghi displayed a willingness to force decisions through a “fait accompli” approach, as he has often done throughout his tenure.  This contrasts with the more collegiate style of his predecessor. We cannot know how Christine Lagarde will operate, but beyond her own style, there will be other changes of personnel ahead at the Council. The market should thus be prudent in pricing in “proper open-ended” quantitative easing and reflect on the room for interpretation left in last week’s decision, given how divisive last week’s decision was.

Indeed, the ECB stayed clear of providing a quantitative definition of its “robust convergence” towards its inflation target. Without an acceleration in core inflation, it is difficult to imagine the Governing Council stopping the purchases, but precisely how much progress needs to be seen may well become a key issue. The Council members who last week opposed QE and are probably worried about taking the risk of making national central banks the deciding force in a sovereign restructuring – which would be a natural consequence of exceeding the 33% limit on bonds bearing a collective action clause – may decide to take a microscope and detect inflation pressure very early.

In sum, we think the bond market would be right to be prudent in reading the ECB’s message. But there is no reason either to expect a strong rebound in yields from where we are. Irrespective of QE, the policy rate is now lower and we suspect that should QE be stopped in case of even a minuscule improvement in core inflation dynamics, the central bank would then fine-tune its new forward guidance to make sure the market would not immediately anticipate an imminent rate hike. More fundamentally, for proper yield normalisation, we think we would need to see a resolution of trade war and/or some decisive fiscal push in Europe. The news-flow on these two issues is keeping us unconvinced that a major break-through will emerge quickly enough to unburden the ECB.

No break-through in sight on fiscal stimulus

Pressure is rising on European governments to ease fiscal policy - not least from the ECB on Thursday which is increasingly clear budgetary action needs to take the lead. Unfortunately, the noises from the European institutions and the German government are not necessarily encouraging.

The Eurogroup meeting in Helsinki last week discussed reforming the rules of Stability and Growfh Pact (SGP) to reach the non-committal conclusion that “prudence on the matter” is of the essence. The thorniest point seems to be the exclusion of public investment from the calculations of thresholds on deficits and debt beyond which member states are dragged into “excessive deficit procedure”. We think the macroeconomic rationale behind this makes sense. Indeed, during cyclical downturns it is  politically impossible for governments to contain current expenditure such as social transfers. Cutting public investment programmes is less visible and becomes the adjustment valve. Statistically it is obvious that government investment has taken the brunt of the austerity drive in Europe since 2010. This is sub-optimal since the deterioration in public infrastructure ultimately reduces potential growth.

The issue as usual is trust. Thrifty governments - mainly in the north - are weary of any major tweak to the SGP which would ultimately be conducive to “runaway” public spending by more spendthrift nations, and it is arguable that even in its current form the SGP has not been very good at ensuring compliance at the national level. Market discipline has been much more efficient, but this is probably eroding in a context of low interest rates for all.

Excluding investment entirely from the threshold calculation may be too blunt an instrument in our view. One may dispute the impact on potential growth of building municipal swimming pools (treated as investment) against raising current spending on education (treated as public consumption). We would favour a narrower definition of the type of public investment which would be excluded from the calculation of the thresholds, for instance using their contribution to cutting CO2 emissions, for which the European Union is issuing more ambitious targets. But for now the EU seems very far away from a consensus on such solutions, and the national initiatives lack ambition.

Last week, Reuters reported a German “Green Bond” project supported by Peter Altmaier, Economy minister, which would inject EUR5bn initially in environmental projects, followed by annual contributions of EUR 1bn. This would hardly move the dial (EUR5bn is 0.15% of German GDP), although just establishing the principle of more action could be seen as a first step. But the financial construction is telling. The state structure would offer zero-interest rate loans, funded by bonds issued to households at an interest rate of 2%, the difference being supported by public finances. So it seems the motive is maybe as much to shield German savers against negative rates than to trigger a proper change in the overall fiscal stance of the country.

There will be an important meeting of the German cabinet on September 20th. Some other initiatives may be unveiled. The Sueddeusche Zeitung last week mentioned a EUR75bn investment programme in railways and electric cars. This would be encouraging, but we would focus on two important aspects of any announcements of that sort: first, how much of the spending would occur quickly enough to spur domestic demand as the external headwinds are strengthening; second, how any additional spending would be articulated with the rest of the German fiscal policy. Indeed, at the current juncture what Germany probably needs right now is a push in overall spending, not a budget neutral reshuffling of spending across projects.

The ebb and flow of the trade war games

Of course, the Euro may not need to spur domestic demand with a fiscal push if the “trade war” resolves quickly. Germany is probably already in recession but the labour market has yet to react, while the economy of France, Italy and Spain remain above the flotation line. Some positive developments have occurred on that front last week, with the US and China postponing some tariff hikes/quantitative curbs on imports.

However, at this stage we still consider those moves as manoeuvring within a very complex game rather than signalling resolution (i.e. a definitive “deal”) is imminent. We would focus on two aspects of game theory to be able to predict outcomes: first, the need to clearly identify the actual goals and timelines of the players; second, that both players are able to correctly anticipate the other player’s reaction to their own moves.

If we assume that President Trump’ final goal is to be re-elected in November 2020, he has probably two ways to achieve this. The first, and probably the option his administration would rather pursue, is to come to a deal with China which will allow the US economy to avoid most of the damage of elevated tariffs and sustained uncertainty, while snatching enough concessions from Beijing to keep the blue collar vote in the swing states on the Republican side in November. The second, probably much riskier electorally, would be to come out without a deal and the accompanying damage on the economy but blame China for this. In both cases the US would need at least to keep the communication channels open and regularly make goodwill gestures. This would suit the Chinese side as well, who would also probably prefer to reach a deal to be able to address the structural issues in their domestic economy without external headwinds, but may decide at the last minute that such deal would be easier to strike, or less costly, with another US President.

This means that the positive tone of last week, unfortunately, does not necessarily tell us much about the final outcome of the trade war. The market reacts to even the tiniest changes of tone, but in the end the issue is binary: will a trade deal be struck. We may have to wait long into next year to know this for sure.

The Fed to cut again

In such uncertain context, the Fed is likely to focus more on the global risks ahead than on the current data flow which at the moment, on the US domestic front, remains decent. The acceleration in core consumer prices to 2.4% is not coming at the best of time for a central bank about to cut again, but the Fed needs to be forward-looking. We expect the FOMC to cut again, by 25 basis points this week. Focus is likely to be on the next steps, and we think the “dots” will indicate some appetite for another cut in December.  

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