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Markets seem to be having a tough time understanding when the ECB expects to start withdrawing the super-loose monetary policy it has maintained over the last four years or so. This isn’t hugely surprising when one considers this week’s about-turn from Mario Draghi.
On Monday Draghi commented with a dovish tone that super-low interest rates create jobs, foster growth and benefit borrowers, whilst rejecting calls to wind in easy monetary policy quickly. By Tuesday he was sounding distinctly hawkish at the ECB's annual policy forum in Sintra:
“The threat of deflation is gone and reflationary forces are at play…we have now enjoyed 16 straight quarters of growth, with the dispersion of GDP and employment growth rates among countries falling to record low levels. If one looks at the percentage of all sectors in all euro area countries that currently have positive growth, the figure stood at 84% in the first quarter of 2017, well above its historical average of 74%. Around 6.4 million jobs have been created in the euro area since the recovery began.”
This bullish and potentially controversial statement went a step further than previous statements from the central bank, which earlier this month dropped a promise to cut rates should conditions worsen. Draghi’s statement will begin to fuel considerable speculation that monetary policymakers could soon be discussing a withdrawal of monetary stimulus - so-called QE tapering.
Draghi cited a number of factors that have influenced his view. The risk of ‘hysteresis effect’ - ongoing economic harm caused by long-term low inflation and growth - has sufficiently reduced. There is evidence to suggest the bank has successfully increased demand across the eurozone. Inflation does still remain weak across the eurozone, but Draghi stated this is more down to global factors and changes in the labour market reducing pressure on firms to raise wages.
Reuters commented that Draghi's comments "sounded to investors like he was ready to give more ground on German demands that the ECB get on with starting to reduce the volume of extra euros it is feeding monthly into the economy." Draghi did offer the caveat in his speech that the ECB would need to keep support in place, given that the rise in inflationary pressure was “not yet durable and self-sustaining. So our policy needs to be persistent…With reflationary dynamics slowly taking hold, we now need to ensure that overall financing conditions continue to support that reflationary process until they are more durable and self-sustaining.”
The market reaction certainly focused on the potential tapering, rather than its caveats. EUR/USD hit 1.1330 by the afternoon and has traded this morning as high as 1.1434 - a level not seen since May last year; 10-year Bund yields were up 13bps to 0.36%; French 10-year yield rose 13.6 basis points to 0.73%; EUR five-year swaps were up 8bps to 0.22%, and EUR 20-year swaps rose 9bps to 1.37% during the day of the speech. Perhaps most telling is that these moves each continued yesterday, and this morning’s price action suggests that there could be more room for EUR strength as EUR/USD interest rate differentials narrow.
The expectation now seems to be that next year the ECB will begin to move towards an end to the current circa €60bn monthly government bond purchases (current total purchases are almost €2trn), with discussions on tapering expected to begin later in the summer of 2018. Expect considerable volatility across credit, rates, FX and equities as investors try to price in, and front-run, what the ECB and other central banks (including the Bank of England, whose Governor, Mark Carney, yesterday suggested rates may rise in the coming months) intend to do.
Meanwhile, Germany is putting pressure on Brussels to close what it considers to be a loophole allowing Rome to provide state aid (in this case of around €17bn) to two stricken regional Italian lenders, bypassing the requirement for senior creditors to take losses. While junior creditors and shareholders will be wiped out, taxpayers are ensuring that senior bondholders are not forced to pay. After the ECB decided that both banks were on the brink of collapse, the Single Resolution Board - the eurozone agency responsible for dealing with bank crises - opined that Italy could deal with banks under the country’s national insolvency proceedings. Crucially, this means it is free to apply earlier state aid rules rather than the new EU rules that were put in place after the financial crisis to ensure taxpayer money is not used to deal with banking crises.
All views expressed here are the author’s own and are based on information available at the time of writing.
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