The latest signals from the European Central Bank

The latest signals from the European Central Bank

By reevaluating the current bond purchase program and refusing to rule out a rate cut, the European Central Bank opened a new set of opportunities for investors. The action also recognizes a slowing Eurozone economic recovery, and will surely rekindle fears of its consequences on growth.

When ECB President Mario Draghi sat in front of journalists after Thursday’s Governing Council meeting in Malta, speculation was high that he would announce an eventual extension of the Quantitative Easing program that was launched last March.

Once again, Super Mario did not disappoint on his determination to do whatever it takes to save the monetary union. The Central banker announced an adjustment in the “size, composition and duration” of the bond-buying program, with a decision to be taken at the next meeting on 6 December.

With several members of the ECB Committee arguing for this action in the last few months, the real surprise came from Draghi refusing to rule out a rate cut into negative territory (interest rates are currently at 0.05%) in an attempt to further weaken the euro.

A move signaling a slowing recovery

This mix of stimulus policies confirms several observations that can be made on the Eurozone’s economic situation, less than a year after the start of the program.

First and foremost, inflation and growth rates have shown worrying signs in the last data and forecasts released; Inflation went into negative territory in September (-0.1%). Even if prices are expected to rise by the end of the year since high oil prices will no longer appear in the data, the number will be far from the ‘below but close to 2%’ target.

Growth also felt the shock of uncertainty in emerging markets over the summer, with the latest forecast for Q3 at 0.3% (as compared to the previously forecasted 0.4%).

Results of the ECB Survey of Professional Forecasters for Q4 2015. Source: ECB

Meanwhile, the euro has been strengthening over the summer against the dollar, further hurting eurozone exports, and stressing the need for the ECB to take action.

Such an outlook is the consequence of a slowdown in emerging markets due to low commodity prices and the dubious maneuvers made by China that hit European markets hard late in the summer. Uncertainty in emerging countries has the potential to further weigh on demand for euro area exports, with emerging markets worth 25% of exports.

Shaping the new stimulus package

Facing such an outlook, the ECB applies a model Draghi had already described back in April 2014. In a speech in Amsterdam, the Central Banker laid out that unwarranted monetary tightening -like a stronger euro – could be tackled by a cut in interest rates, and that a worsening of inflation would require a broad-based asset-purchase program.

In the next few weeks the Executive Committee will look at a range of economic indicators – including inflation, jobs, and confidence data to be rereleased next week – before actually designing the new program.

The ECB will also watch data from the U.S., with the eventuality that the Fed will raise interest rates at its next meeting – which will be held two weeks after the ECB’s. If the Fed is expected to raise interest rates, the monetary tightening will result in the dollar strengthening against the euro. Depending on the reaction in European bond markets, this could entice Draghi to limit the new stimulus package, at least until the Fed actually makes a decision.

But if the Fed is seen to delay a rate hike with an indication that the U.S. economy remains too weak for tightening, it is likely that the ECB will seek to compensate with an ambitious plan combining more quantitative easing (QE2) and a rate cut into negative territory.

QE2 in itself could take the form of an extension of the current program beyond the initial end-date of September 2016, potentially with higher purchases than the current €60bn/month.

Investors enjoy the ride while concerns arise

Meanwhile, markets reacted positively after the press conference. The euro was down 3.05% for the week against the dollar (see chart below), and investors rushed to buy the precious Eurozone bonds susceptible to be the target of the ECB in the next phase of bond purchase. Consequently, European stocks and bonds rose straight away, while German bond yields reached a record low.

Euro to Dollar conversion rate. Source: Bloomberg

Investors might be rubbing their hands at the prospect of an upcoming QE2, but concern is growing over the effect of another stimulus package. Critics argue that such monetary easing creates the potential for asset bubbles and distortions in bond markets.

Record-low yields obtained from QE are suspected to have an impact on the solvency of pension funds and life insurers, potentially undermining demand in the currency area and thus provoking a counter-productive effect on growth and inflation.

Detractors of monetary easing also feel that quantitative easing can become addictive for economies that struggle to recover, because they tend to rely on the stimulus and avoid introducing structural reforms.

The periphery prepares for more instability

Not only will QE feed concerns within the Eurozone, but the eurozone’s neighbors (whose economies are highly impacted by the ECB’s actions) are about to experiment real tests.

In the periphery, the new stimulus package will force national central banks to adapt by cutting rates, and possibly extending their own easing programs.

Denmark, whose currency is pegged to the euro, will likely cut its interest rates further into negative territory in order to avoid too much pressure on the krone. This could have a catastrophic effect of creating a real estate bubble, with apartment prices in Copenhagen that already soared as much as 60 percent since 2012.

Switzerland will probably feel more pressure from its deflationary problems after last year’s decision to de-peg the Swiss Franc from the euro, which caused the franc to soar. Sweden will be forced to reevaluate its own QE program, and probably cut its rates further into negative territory.

Overall, the ECB’s hint at further monetary easing will open opportunities for investors in the eurozone and its periphery, but consequences in the longer term will have to be watched closely. The drawback could be felt strongly if detractors of monetary easing prove right, and in any case monetary easing alone will not solve Europeans’ economic troubles.

Categories: Europe, Finance

About Author

Julien Freund

Julien is an analyst with a focus on Europe. He has worked as a lobbyist in Paris and Brussels and has written extensively on the rise of nationalist parties. He holds two master's degrees in geopolitics and international relations and in European relations, and received his BA in economics and social sciences from the Catholic Institute of Paris.