A particular talent
Today's news headlines:
- ‘EU criticism of Johnson’s "unacceptable" Brexit terms sets scene for bruising talks'. Michel Barnier has written to 27 EU member states, urging them to hold their nerve following Boris Johnson’s combative speech in Parliament. In order to reach an agreement, Johnson has demanded the abolition of the Irish border backstop. Johnson has also promised to 'turbo-charge' preparations to leave the EU without a deal on October 31st. (Financial Times)
- ‘US increases aid for farmers hit by China trade dispute'. The second round of bailout payments to farmers since 2018 will cost the US government $16bn, as the effect of retaliatory trade tariffs are felt. The main recipients will be producers of soybeans and pork, with the amount based on the maximum amount trading partners could have imported over the last ten years. (Financial Times)
There's no doubt about it; the top job at the European Central Bank (ECB) is tough. Yesterday, Mario Draghi defied expectations—a particular talent of his—and kept monetary policy on hold. This is not a rejection of the need for stimulus within the Eurozone, but rather a sign that the necessary medicine isn't palatable. With the US almost certain to move to an easier setting on July 31st, most of the world is making preparations to follow suit or have beat them to the punch. Of course, the problem in Euroland is that they are already on a ZIRP (zero interest rate policy) setting with deposit rates at -0.40%.
There are two key issues with this status quo. The premiums banks receive for providing liquidity to funding markets are compressed, so the incentive to lend is reduced. Various ECB committees have been exploring a tiering system which aims to reduce the stress on banks, but a few governing council members have anonymously expressed doubts of its e fficacy. The second issue with ZIRP is that little slack for easing remains in the event of a more dramatic economic downturn. Even so, Mario Draghi signalled that easing would likely come in the September meeting, while strenuously arguing for fiscal policy response, especially German.
Bottom line: This isn't a new position for the ECB president, but the German domestic politics are overwhelmingly opposed to deficit spending. This makes little sense when the cost of borrowing (German Bund yields) is negative, and they regularly have budget surpluses. In order to create a fundamental change in political stance, the pain will need to ratchet up. Looking at some of the EU fundamental data releases, this is more a slowdown than a plummet, which suggests things will need to be quite severe before collective awareness of the danger occurs.
Deteriorating economic data has forced central banks around the world to shift towards monetary easing, but after a decade where central banks have shouldered the burden for growth, not all banks have the same policy flexibility remaining. While US data remains strong, most developed market economies are showing clear signs of contraction. A goodly proportion of this slowing economic activity can be attributed to geopolitical risk, like the US-China trade tensions, which has reduced private sector investment and certainty about global supply chains. The outlook has deteriorated, but largely due to central bank support, we have so far avoided outright contraction.
Yesterday, the European Central Bank (ECB) kept its policy rates unchanged, and it is expected that the Bank of Japan (BoJ) will keep rates at -0.1% next week. While pressure has been mounting on central banks to cut rates, those near the ‘zero lower bound’ may find the marginal benefit of further rate cuts is too small. Instead, central banks such as the ECB and BoJ are likely to retain the limited tools at their disposal for an outright recession. Clear monetary policy has been doing all of the heavy lifting, so the argument for fiscal policy support is only growing.
Bottom line: Pressure is mounting for future interest rates to change, but changing forward guidance too regularly undermines central bank reliability; Japan is in such a position given its forward guidance tweak just three months ago.
The pair has been trading in a tight range throughout the month of July and yesterday was very much the status quo. Recent selling bias in the Pound has been evident as the Sterling Index’s 100-day moving average has crossed the 200-day. The sell-off may continue as markets eye US GDP growth data released today.
The cross strengthened to its highest level in the month of July but ultimately ended the day lower than the open. The pair fell throughout Draghi’s speech as markets digested a lack of ECB cohesion over future policy stimulus. Renewed clashes over Brexit also pushed Sterling lower.
We saw some interesting price action around the Euro following the ECB announcement that kept rates on hold. Initial weakness was wiped out as the pair climbed close to 0.8%, before tailing off back towards pre-announcement levels by the end of the day. Technically, this means the overall outlook hasn’t really changed, and risks remain tilted to the downside.