The President of the European Central Bank could very well have the worst job in the world. 1 1 Close It sucks to be the ECB. It sucks to have falling inflation expectations and rates at negative forty. It sucks to be the ECB. (Everyone’s a little bit monetarist over here on Avenue AQR.) He has the almost impossible task of managing the currency of a motley group of countries, each with differing economic interests and philosophies. The ECB faces criticism from every angle. In fact, criticism of the ECB may be the one position that German and American politicians can agree on. Bundesbank members argue that the ECB has gone too far with its stimulus. A group of German academics and politicians brought a lawsuit, that made it to the European Court of Justice, claiming that the ECB’s quantitative easing program violated European law. 2 2 Close They lost. , 3 3 Close Reuters: “German challenge to ECB asset buys sent to European Court,” 8/15/17. Across the Atlantic, President Trump accused the ECB President (referred to in one tweet as “Mario D”) of tanking the euro to give Europe an unfair advantage in trade. 4 4 Close Did the ECB Executive Board start way back in history with Ad-Rock, MCA, and Mario D?, , 5 5 Close Wall Street Journal: “ECB Signals Possible Rate Cut Prompting Trump Tweets,” 6/18/19. Meanwhile, Italy is discussing adding something resembling a parallel currency. Even soon-to-be former British Prime Minister Theresa May’s job seemed easy next to this. All she had to do was negotiate a Brexit deal.
The ECB’s primary mandate is to keep inflation below, but close to, 2%. 6 6 Close European Central Bank. With eurozone inflation currently at 1.2% YoY, the ECB is technically meeting its remit. The problem is that 1.2% is on the low end of what can be considered near 2%, and there is a material risk that inflation trends lower. 7 7 Close There is some controversy as to whether the ECB should be concerned about that. Some think it should have a narrow remit and just try to keep inflation below 2%. Inflation expectations, as measured by swaps, have fallen sharply, indicating that markets are doubting the ECB’s credibility. 8 8 Close Five-year forward five-year inflation swaps, a commonly cited market-based measure of estimated price increases in coming years, fell to a record low of 1.13% on June 14, 2019. Source: Bloomberg. European economic growth has not been great. Consumption has held up, but investment numbers have lagged. Manufacturing surveys in several countries, including Germany, are showing contraction. The continent is not in recession, but its economic performance has been disappointing. It would seem like the ECB would be considering additional stimulus.
What makes this situation so frustrating for ECB members is that monetary policy is already very loose. The ECB balance sheet remains near the largest it’s ever been, and the deposit rate is at -40bps. 9 9 Close European Central Bank. It is possible that individual countries will help on the fiscal side, but it doesn’t seem like there is a consensus in favor of the kind of tax cuts or spending needed to meaningfully impact the economy. Draghi’s term ends in a few months. It might make sense for him to leave gracefully and leave the disinflation to his successor. But that wouldn’t be Mario D!
Draghi seems like the kind of guy who takes his “whatever it takes” catch phrase very seriously. 10 10 Close President Draghi gave a speech during the European debt crisis in 2012 in which he stated the ECB would be “ready to do whatever it takes to preserve the euro.” This has been remembered as a key positive turning point in the debt crisis. Source: European Central Bank: “Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London,” 7/26/12. He probably gets up in the morning and says he’ll do whatever it takes to brush his teeth. In Sintra, Portugal this week, he invoked that spirit: “In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.” 11 11 Close European Central Bank, Mario Draghi: “Twenty Years of the ECB’s monetary policy,” 6/18/19. However, many economists doubt that the ECB has the tools do whatever it takes. The ECB has already announced targeted repo operations, but they are fairly limited in their impact. The ECB is unlikely to use exotic measures, such as yield curve control, so that leaves two of their old favorites.
The first option is additional quantitative easing. There is a strong argument that QE has been more effective in Europe than in the U.S. or Japan because it has a natural credit dimension. When the ECB buys sovereign bonds of lower credit countries it is essentially removing risky debt from the open market. 12 12 Close Technically the sovereign bonds are held at the central bank of the individual country, but this distinction is less important than people think. This is known as credit easing, but it has a downside. Many economists in safer credit countries view it as a backdoor way of forcing them to assume the risky debt. Italy is the largest issuer of government bonds in Europe and it has a lower credit rating than Germany, so any program which buys a substantial amount of Italian bonds would likely be very controversial. Italy and the EU have not been getting along very well. Buying negative-yielding German Bunds probably won’t have much of an effect on the economy, so the ECB will have to think carefully about how it would put together another QE program. 13 13 Close In the past, the ECB has used a total population and GDP weighted formula for deciding the amount of each country’s bonds to buy, which resulted in larger purchases of German Bunds than Italian BTPs. Even using this weighting again would probably still be controversial.
The ECB could also cut interest rates further. Rates are negative, but other central banks, such as the Swiss National Bank, have shown that there is room to go even lower. More conservative ECB members seem a little more comfortable with negative rates than QE because they don’t involve any implied monetization. Banks, on the other hand, are not happy about having to pay for deposits at the ECB. They point out that it is difficult to pass the costs to retail depositors. Initially, the ECB was unsympathetic to their concerns, but now members seem willing to consider tiering programs, which would allow the banks to make some deposits at the ECB at higher rates. Some economists have questioned the effectiveness of negative rates, but Draghi seems to think they are helpful in stimulating growth and inflation. He may be wrong, but his belief will probably drive policy in the near term.
For investors, the main takeaway is that the ECB is likely to act before Draghi leaves in October. He wants to protect his legacy and will likely push back against political pressure. Any action will require getting enough of the other ECB members to join him, which is never guaranteed. The two tools at the ECB’s disposal, QE and rate cuts, have technical issues. We would guess that rate cuts are more likely, but both are on the table. Markets have slowly started to price this in. The talk of additional stimulus is probably helping European equities. It may even be helping to weaken the euro, but it’s not enough to make Draghi’s last few months on the job any easier.
What We Are Watching
U.S. Durable Goods Orders (Wednesday)
Durable goods orders provide a monthly update on trends in capex spending by U.S. firms, an important piece of the economy that has experienced slower growth in recent quarters. The April release showed a sharp fall in so-called “core” capital goods, 14 14 Close This category excludes aircraft and defense-related orders. disappointing expectations for a moderate increase, and March orders were revised down significantly as well. The data suggests that capex was already deteriorating before the most recent escalation in U.S.-China trade tensions (more on this below). The increase in global trade uncertainty since early May could weigh further on U.S. capex. Market participants and policymakers will be watching the May data to assess the extent to which business investment has weakened in recent weeks. Another poor result could add to growing expectations for rate cuts from the Fed, boosting fixed income and weighing on the U.S. dollar.
G20 Meeting (Begins Friday)
The G20 summit scheduled to begin in Osaka next Friday has become a focus for market participants largely because of a planned side meeting between Presidents Trump and Xi. Trade negotiations between the U.S. and China suffered an expected setback in early May, raising concerns that the trade dispute between the two countries could re-escalate. Furthermore, economic data has pointed to weaker growth in the U.S., China, and a number of other countries in recent months, a sign that trade uncertainties may be weighing on the global economy. While talks between Trump and Xi are unlikely to yield an immediate agreement, they may provide a sense of how likely it is that progress will be made in the weeks and months ahead. Equity market sentiment would likely receive a boost if the meeting concludes with positive statements from both sides and indications that further tariff increases will be put on hold while negotiations resume. Conversely, a negative tone and renewed talk of additional tariff increases could lead to a selloff in stocks. A disappointing meeting could also increase the odds the Federal Reserve begins lowering rates as early as its next meeting in July.
Canada Monthly GDP, Quarterly Business Outlook Survey (Friday)
The Canadian economy has been showing mixed signals recently. Despite recent positive surprises to employment data, GDP growth forecasts for 2019 have continued to be revised lower. 15 15 Close Bloomberg economic survey median forecasts for 2019 GDP have been revised down from 1.9% as of the end of 2018 to 1.4% as of June 20, 2019. Source: Bloomberg. This week’s GDP release for the month of April will be dissected to see if softer trends in the mining, transportation and housing sectors are showing any sign of stabilizing. Another key release, the Bank of Canada’s quarterly Business Outlook Survey, will provide insight into shifts in business sentiment. Last quarter, businesses noted easing capacity constraints and slowing growth. Concerns around the energy sector, housing and global trade tensions were mentioned as headwinds. This week’s survey will be watched to see if these headwinds have worsened in recent months. Downbeat results in these data releases could add to speculation that the Bank of Canada may consider policy easing in the months ahead.