It’s the most anticipated event of the week for the financial markets, as the ECB is set to announce its monetary policy in what will be President Draghi’s final act before his term expires at the end of next month.
Only last month were global monetary easing expectations significantly rising, with rate cuts out of central banks in India, New Zealand, and Thailand setting the stage for cheap money to flood the system. Thus far however, those hopes have been diminished somewhat, with last week’s main central bank announcements out of Australia, Canada, and Sweden keeping rates on hold, and ECB officials mimicking what Fed officials did prior to the July 31st rate cut with talk that would at the very least deny an aggressive easing package out of the ECB.
With the lightweights out of the way, attention now turns to the heavyweights with the ECB this Thursday set to offer some sort of easing to aid its troubled Eurozone and followed by the Federal Reserve next week whereby markets are majority pricing in a 0.25% rate cut. But unlike the Fed where internal division is rising on how to keep the US expansion going, the ECB’s problem is how to prevent countries like its manufacturing powerhouse Germany, from slipping into a recession.
It’s no secret that manufacturing globally is in a recession, with last week’s US ISM PMI registering its first sub-50 contracting figure since 2016 and following what has been contractions in both German and Chinese manufacturing sectors (to say the least). That makes countries reliant on manufacturing – and exporting those manufactured goods in the current trade war climate – at bigger risk of suffering a recession.
And last time around Draghi highlighted an outlook that was getting “worse and worse”, though mentioned that he expected recessionary risks to be “low”, waiting for more data before acting. At the time it was understandable and gave central banks a sigh of relief for had the ECB acted with easing, it might have sparked an easing cycle from central banks of countries looking to keep exports competitive, and their currency weak in the process. Those recessionary risks are too difficult to ignore at this stage, and in light of the fact that the catalyst for worsening data this time around is a trade war, unlike 2008 where globalization was still rising.
So, what exactly are the ECB’s options? Cutting rates into negative territory would require offsetting with aid for banks suffering from negative interesting rates, ‘low for longer’ would be seen as too little and likely fail to prevent a recession from occurring, and resuming asset purchases (of government bonds) would give the bloc’s governments a lifeline and aid fiscal stimulus at a time when recessionary risks are fueling anti-establishment (and anti-EU) sentiment, with gains in populist parties eroding establishment majorities as witnessed most recently in Germany’s Eastern state elections.
But there’s more. Investor reaction in the financial markets thus far has been to buy up European government bonds with Germany’s 10-year and 30-year both in negative territory, anticipating that the ECB would in turn be forced to buy up those bonds should a fresh round of easing occur, where the outcome has usually been that both bonds and equities are the beneficiaries as money is forced into riskier assets, and explaining why the German DAX hasn’t suffered heavy losses even as data continues to disappoint. It also explains why yields elsewhere have been dropping as investors consider assets outside the EU, with Norway’s sovereign wealth fund manager recommending a shift towards US assets that offer higher returns, an action pension funds will have to consider given the increased pressure to perform as obligations rise on demographic shifts.
Should the ECB introduce a lighter easing package, or avoid purchasing government bonds altogether, and the bond market globally could be in for a rude awakening, with investors dumping negative-yielding debt (they ideally should have never purchased in the first place had it not been for the assumption the central bank would buy it eventually), and making lending more difficult for governments at a time when fiscal spending looks set to increase, for whether it’s the government being paid to lend out money, companies that are issuing bonds, or new homeowners entering the market, they would be the beneficiaries of negative interest rates and at the expense of savers, banks, and pension funds seeking returns.
The alternative isn’t necessarily brighter, for if the central bank announces they’ll buy up those bonds, it’ll ensure that the hunt for yield remains difficult and force greater risk-taking, which may worsen a future recession given the ’08 crisis was credit induced with money piling into risky assets. However he may choose to bow out, Draghi’s eight-year term looks set to end with a most difficult and unenviable choice.
* Any opinions expressed in this article are the author’s own
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© Opinion 2019