DRAGHI: MONETARY TRANSMISSION WORKING LIKE A DREAM
When the ECB president said last week that the monetary transmission mechanism had never worked better, he was probably exaggerating deliberately. But still, he seemed pleased with the outcome of current ECB policy: credit markets in the eurozone are no longer fragmented and credit is reaching the private sector. Draghi pointed out that negative side effects such as lower bank profitability or cash hoarding have been limited – so far. With inflation low, but stable (see chart) and a relatively positive economic outlook, the ECB did not see any reason to extend its asset purchasing programme. The topic did not even come up at last week’s council meeting.
Markets initially reacted negatively, but this was all short-lived. In itself, that can be seen as positive since it could indicate that markets have finally become less addicted to monetary policy accommodation. However, we think the main reason is that the ECB left the door open to an extension of the programme at a later date, reviving some of the market expectations.
What the council did do was task committees to look at the options for a smooth implementation of the asset purchases in the context of the (growing) scarcity of some of the bonds the ECB is buying under the programme. Unless the pace or the rules are changed, the ECB may run out of German Bunds to buy later this year or early next year.
So what can change between now and December? Economic growth may disappoint the ECB’s relatively optimistic projections. Low inflation, already a concern for the ECB, is unlikely to pick up, even with accommodative monetary policy and exceptionally supportive financing conditions. So once the committees have found ways around the scarcity of selected bonds, we expect the ECB to extend its asset purchase programme by six months then.
MARKETS DON’T BELIEVE THE FED, OR DO THEY?
While selected weak data has lowered the probability of a US rate rise this month, Fed committee members have continued to send hawkish signals. Boston Fed President Rosengren that low interest rates were boosting the chances of the economy overheating, adding gradual monetary tightening was appropriate. Looking at the pricing of fed funds futures, these do not reflect such hawkish comments being translated into policy tightening any time soon.
But markets did react strongly to the change in the tone of central bankers. Rosengren’s words sent stocks and bonds lower and the sell-off continued on Monday. This indicates that markets are still reckoning with a rate increase. A move as early as this month would open the door to follow-up action in December since it would be seen as signalling increased confidence at the Fed in the enduring strength of the US economy. Were that to happen, markets would have to start to discounting two rate rises this year instead of just one.
However, we think recent weakness in data including the latest labour market report and ISM indices (see chart) has made a rise this month less likely. While other timely indicators such as initial jobless claims, consumer confidence and housing market data are not signalling a sharp slowdown in the economy, some regional indicators have weakened and the Fed’s own Labour Market Conditions Index is back in the red. This all should be enough for the Fed to hold policy.
CHINA TRADE STRENGHTENS
Chinese trade data came in stronger than expected in August. The decline in exports slowed and imports surged, showing growth again (see chart). This may point to higher domestic demand related to infrastructure spending and the strength in the real estate sector. Other factors such as the reconstruction of flood-damaged areas and the positive technology cycle that has developed in Asia, partly on the back of the release of Apple’s iPhone 7, could be more temporary factors. Foreign demand has not improved by much. So we would want to see more evidence before becoming more optimistic on the Chinese economy.
ASSET ALLOCATION: A SPIKE IN VOLATILITY
The Fed telling the markets that another rate rise is getting closer, the ECB seeing no need to extend its asset purchase programme and the lack of clarity on what the comprehensive reassessment will mean for monetary policy in Japan have injected volatility into the markets (see chart), causing an equity correction and yield curve steepening. So markets are still highly dependent on monetary policy (which also explains why we write so much about it).
As said, we are not changing our cautious stance at this point: underweight equities, underweight emerging market debt in hard currency versus US Treasuries and underweight commodities. We prefer US government bonds over broad eurozone government bonds for the higher carry and the roll-down yield in the US and given the higher political risks in the eurozone. We also prefer eurozone inflation-linked bonds over nominal bonds as the inflation expectations embedded in linkers look too low to us.
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