Mario Draghi recently stated the “downside risks have increased again” and “in this environment, euro area inflation dynamics also continue to be weaker than expected. It will therefore be necessary to review and possibly reconsider our monetary policy stance at our next meeting in early March, when the new staff macroeconomic projections become available.”
Recent data releases from the Eurozone suggest further policy action is inevitable. For example, data for the month of December in Germany, one of the stronger areas in the Eurozone, points to an economic slowdown; retail sales fell -0.2% mom, industrial output fell -1.2% mom, factory orders -0.7% mom and exports were down 1.6% mom. Also of concern is that inflation expectations, as shown by the five year five year euro inflation swap rate, which has fallen from 1.8% at the end of November 2015 to 1.4% at the time of writing.
Benoît Cœuré, an ECB Executive Board Member, noted of ECB policy “we will not react to short-term changes. We’ll react if our analysis shows that the fundamentals, underlying factors change. So, for example, growth in the emerging markets is something we’re watching. The inflation trend in the eurozone is obviously something we’re watching. But we look at the medium-term trends.” But as the January ECB minutes and Q and A note the oil price expectations are stretching beyond being able to be dismissed as ‘a short-term effect’. Moreover, since the cut-off for the December projections the oil price is down ~40% and there is the issue of second-round effects to consider i.e. whether “low commodity prices do feed into other prices.”
But the issue facing markets at this stage is twofold: First, that further rounds of Q€ or more negative rates are becoming less effective, particularly if central bank easing becomes a game of competitive devaluation with no real winner; Second, that policy responses are over-reliant on monetary policy. The ECB notes “in order to reap the full benefits from our monetary policy measures, other policy areas must contribute decisively” but this is constrained in that “fiscal policies should support the economic recovery, while remaining in compliance with the fiscal rules of the European Union.” But for Eurozone elevated debt levels have meant that fiscal policy has taken more of an austerity bias. Thus, the ECB emphasises the importance of “effective structural policies.” Unquestionably, structural reforms to improve competitiveness and productivity would be positive for growth but this tends to be over the medium term.
But as we go further into the realms of negative interest rates with Japan starting to move in this direction, the Riksbank move on Thursday taking deposit rates to -0.5% and the ECB expected to do more next month, the market is starting to question the effectiveness of QE and negative rates in promoting growth in the real economy and any unintended consequences. Hence financial stocks have been brutalised as questions arise on the impact of negative rates on their profitability and ability to function in ‘unchartered territory’ and ‘safe haven’ assets such as Treasuries have been well bid.
For us this uncertain environment favours positioning in higher quality credits from ‘wealthy nations’ and bonds with a longer duration as the yield curve continues to flatten.