ECB and Draghi to Expand QE — Fed goes “Dovish” Without Cutting Rates

Tom Cleveland

This past week was filled with surprises from both the ECB and the Fed, as observers witnessed dovish moves on the part of both central banks, while neither one cut interest rates. The positioning on both sides of the Atlantic is to gear up the printing presses again and get the “cheap money” flowing as quickly as possible. If there is to be a global economic slowdown in the near-term future, equity markets were having none of it. Stock prices rising across the board was the tune of the week, as prospects for more accommodating monetary policies swept across the globe.

Everything was up, including Bitcoin, too, if you have been following cryptocurrencies. The only thing that seemed in freefall was the U.S. Dollar, slipping from 97.7 on its index early in the week down to 96.1. The Fed may not have cut rates, but the market in a flash priced in two rate cuts for 2019. On the other side of the pond, Mario Draghi, who plans to step down soon, revived his old “Whatever it takes” stump speech and announced to stunned reporters that the ECB was to expand, not tighten, its QE plans. The Euro and Pound responded accordingly, rising 150 pips apiece for the week.

The European economy is in disarray, refusing to respond to stimulus or to meet inflation targets. Manufacturing is the primary disappointment, as the obvious trend in the chart below reveals:


What is the current narrative in the EU and what is the ECB prepared to do?

As was reported: “Mr. Draghi’s speech in Sintra, Portugal, a few days ago, was reminiscent of his famous “Whatever it Takes” speech. Mr. Draghi said the bank had “considerable headroom” to launch a fresh expansion of its $2.9 trillion Quantitative Easing program and suggested it could, in the short term, target inflation above its medium-term goal of just under 2%, for a limited period of time. Virtually no one was expecting this. It had been thought, by most money managers, that the ECB was done with QE and while they might flat-line, that no increase in QE was in sight.”

Markets today are truly global. While many analysts have been focused on what the Fed might do, actions by other central bankers, especially the ECB, can have just as much influence on overall market positioning. With the prospect of more easing, rates fell across the EU, with France’s 10-Year Note hitting “zero” for the first time: Switzerland -0.57%; Germany -0.32%; Denmark -0.29%; Netherlands -0.17%; Austria -0.05%; Finland -0.03%; Sweden -0.03%; France 0.00%; and for comparison, the United States 2.06% (Before its Fed meeting).

The ECB has been holding interest rates down in hopes that economic activity would soon pick up and drive inflation, but nothing of the sorts has occurred. Critics generally point to structural issues that EU politicians have refused to address, namely their very expensive social programs, at least when compared to the rest of the world. The contention is that the central banks has had to maintain interest rates at a consistently low level in order to keep their member countries competitive in an increasingly inter-connected global marketplace.

Southern member states were non-competitive long ago with a general lack of broad-based manufacturing capabilities, but the industrial north has finally succumbed, as well, if the decline in manufacturing PMI data is any indication. German bund rates are just one more bit of evidence that there has not been a turnaround in prospects going forward, as evidenced by the chart below:

Bund rates decline

Other critics point to U.S. protectionism and protracted trade negotiations as the real culprits. The response has been that central banks are willing to step in to combat tariff hikes with interest rate cuts, which have a way of creating more favorable foreign exchange rates for trade. For the time being, as Mario Draghi contemplates his departure, he has been more than willing to pull out the stops, create expectations that his successor will be bound by his commitment for further monetary easing, and then basically say “all options are on the table to return inflation to below but close to 2%.”

Despite Draghi declaring, “Whatever it takes”, the more important “déjà vu all over again” scenario has been the stubbornness of inflation rates in the European Economic Union. The facts on the table were that, “With eurozone core inflation falling to 0.8% year-on-year in May and 5-year forward inflation expectations falling to under 1.2% in recent weeks,” the ECB had to act aggressively.

The actions taken early in the week, however, put additional pressure on the U.S. Fed to act in a similar fashion. Analysts were quick to respond that: “Europe and China are trying to “ring-fence” the United States.” The new narrative quickly became: “With central banks on both sides of the Atlantic in easing mode for the foreseeable future and global political tensions remaining elevated, government bonds and gold are likely to continue to find favour amongst investors.”

What did the Fed do in response and how did markets react?

The Fed reaction could be termed as surprising, as well. Per reports: “The most important thing to note about the June FOMC is that the Fed managed to clear the bar for a dovish surprise without actually cutting rates. That was no small feat. As tariff threats escalated and weakness began showing up in US economic data, folks piled into a variety of trades, which all in one way or another amounted to bets on the “imminent rate cuts” narrative”.

Without a specific rate cut to guide the discussion, analysts immediately went into Fed-speak analytical mode. Chairman Powell’s words were heavily dissected, as were the voting behaviors of the members of the FOMC. Revelations from this “post-mortem autopsy” fell into an assortment of conclusions”

  • First, in the past the Fed’s wording carefully stressed that “patience” would be their guide going forward, but this time around, they substituted a commitment to “act as appropriate to sustain the expansion”.
  • Second, Powell has lived in a world where unanimous consent from his board members was a given, but Jim Bullard chose to dissent at this meeting. The market has a way of fastening onto dissent, as if arguments and tension have invaded the Fed’s decision-making process. Markets abhor uncertainty;
  • Third, the Fed’s rate plot diagram reflected that eight governors expect rate cuts in 2019, while seven of them declared 50 basis points as the appropriate amount. The Fed benchmark range sits at a steady 2.25% to 2.5%. After the meeting, Barclays noted that: “We had anticipated that no more than three participants would project a rate cut.”
  • Fourth, The Fed lowered its forecasts for inflation, as Powell explained that: “Inflation has been lingering and not getting back up to target in a sustained symmetric kind of way.”
  • Lastly, during Powell’s press conference, one reporter mentioned that academic studies revealed that “cutting rates aggressively (versus tentatively) when policy is near the lower bound” is best and would suggest that the Fed might consider doing the full 50 basis point cut in July. Powell’s response: “An ounce of prevention is worth a pound of cure, and that is a valid way to think about policy”.

The market’s interpretation of an “ounce of prevention” was that the full amount was necessary. It quickly priced the 50 basis points into 2-year Treasury yields, and bond markets were off to the races. For the first time since November of 2016, 10-year Treasury yields fell below 2%. Equity markets also surged, content that cheap money and easy liquidity would continue unabated for at least a while longer. The general conclusion was that the Fed had no option but to enact the full cut next month.

Analysts over at Nomura Holdings remarked: “The “QE-trade” is back in a major way overnight following yesterday’s Fed, the 2nd consecutive “dovish surprise” from a major following the ECB’s own heavy tilt “easier” on Tuesday… Just an epically “dovish” message from the Fed, which evidences the most likely “easing” path to be one where they will CUT BIG and FAST in light of the proximity to the effective lower bound, in order to “prevent a weakening from turning into a prolonged weakening” (Powell’s words yesterday).”

How have recession models been reacting to market conditions?

We can presume that a flood of articles will now appear that warn that a recession is once again imminent, as it has been for years. Yes, economic data is turning downward, but models have a way to go before red alerts start flashing. Here is just one chart on topic:

Recession Model

Data points may have shifted to the negative, but bells are not ringing just yet. The progenitors of these various models do not see a recession happening in 2019. The focus, however, remains on 2020, but their discussions highlight where they think the weak spots or vulnerabilities are in the global financial infrastructure. These “think tanks” are primarily concerned with the level of global indebtedness, and that: “Government debt in the euro area remains one of the most serious vulnerabilities dogging the global financial system”.

Bloomberg just reported that: “The universe of negative-yielding bonds grew about $1.2 trillion last week, pushing the total past $13 trillion for the first time.” Total global debt is estimated to be at a record $244 trillion, which is more than 3 times the size of the global economy. U.S. tops the list at nearly $20 trillion in national debt. China and Japan trail at $17 and $9 trillion, respectively. The more important Debt-to GDP ratio in the U.S. is 106% and shows no signs of declining in the near term.

A weak spot in the U.S. that could “amplify and spread an unexpected economic shock” is seen to be the alarming increase in corporate debt and the willingness of investors to put more capital at risk with companies with poor credit ratings. These experts see the “cracks” and sense that the bedrock of the global financial system is at risk, especially, if and when interest rates rise, currency rates are in chaos, and protectionism moves to unanticipated extremes. The consequences could be immediate and global.

Concluding Remarks

Central bankers are at it again, trying to keep the global economic ship afloat with accommodative monetary policy, while debt keeps poring through cracks in the hull and weighing heavily on future prospects. At this moment, all we have is rhetoric from these scions on high. Niether the U.S. nor the EU cut interest rates, but financial markets responded by pricing in expectations, just the same. The can has been kicked down the road. Let’s hope it floats a while longer.

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Tom Cleveland
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