Thoughts through the cycle: W2 September ’20

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The ECB – hapless or just helpless?

  • The euro was born on the 2nd January 1999, weighing $1.17 against the dollar. After an extended bank holiday weekend to allow the financial world to convert its data and computer systems from the 12 individual currencies into euros, the euro traded up to $1.18 on its first day. The occasion was celebrated with a small street party outside the ECB headquarters in Frankfurt in which the band somewhat incongruously played ‘Land of Hope and Glory’. History does not relate if the words were sung. At the ECB policy meeting on 10th September 2020, the euro was also trading at $1.18, although now this appears to be a problem such that it attracted most of the questions during ECB President Lagarde’s subsequent press conference. What is going on?
  • As can be seen from the graph below, the euro has steadily strengthened against the dollar since the crash in March. While the ECB has augmented its existing quantitative easing (QE) programme with a Pandemic Emergency Purchase Programme (PEPP) of €750b (with an additional €600b on 4th June), in many ways the story of the strengthening euro is really one of a weakening dollar. The Federal Reserve has outpunched the ECB in terms of the volume and alacrity of QE and, in addition, has been able to cut interest rates. While the ECB went into the crisis with policy rates already negative, the Fed Funds rate has fallen from just over 1.5% to 0.1%. The 10yr US real rate (10yr nominal rate less inflation) has fallen from 0% to -1%, a big number in this context and probably the key factor in explaining recent weakness in the US dollar.

Source: Bloomberg, 11th September 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • One of the consequences of a strengthening currency is falling inflation. Disinflation usually describes a period of falling inflation, while deflation describes a period when prices are actually lower year-over-year. CPI inflation for the Eurozone fell from 0.4% in July to -0.2% in August per the graph below. This is deflation by any normal definition, although not according to Christine Lagarde. When asked about this figure during the ECB press conference, Lagarde made an enormous flap of explaining how the negative number had been arrived at, but then concluded somewhat unexpectedly that deflation was not a “description of a situation we are interested in” because the risks causing the negative print had receded.

Source: Bloomberg, 11th September 2020.

  • This is not the first time a President of the ECB has contorted language to deny an empirical fact about inflation. First prize goes to Lagarde’s predecessor Mario Draghi who in a similar ECB press conference on 3rd September 2015 said, “We may see negative [inflation] numbers in the coming months. Is that deflation?” The answer is yes, Mario, it is. Why the big fuss? Deflation is a trap from which it is very difficult to emerge. In his General Theory of Employment, Keynes makes it very clear that the threat of deflation is far worse than that of inflation as the former affects labour (through unemployment) while the latter affects capital (through reducing purchasing power). He argues that the social dislocation of falling wages and unemployment provides the gateway to authoritarianism and, in the 1930s about which Keynes was writing, to fascism.
  • What makes Lagarde’s argument so feeble are the obvious inconsistencies. While acknowledging that a stronger currency is deflationary, the ECB’s own inflation outlook for 2021 has actually been increased from 0.8% to 1.0%. This is entirely counter-intuitive. While Lagarde says she is not concerned by short-term negative-inflation prints but looks instead to the medium-term, the ECB’s 2022 inflation forecast is only 1.35% versus a stated target of 2.0%. Looks like we have no inflation in the medium term either, Christine.
  • Arguably, the main factor in deflation is debt – the larger the stock of debt, the more the servicing cost (interest payments) reduces debtors’ ability to consume. Over time, the decline in consumption (falling demand) results in falling prices. This is true even with low interest rates. In fact, low rates reflect tight monetary conditions, themselves the product of the overall build-up of debt. In the Eurozone, with its half-formed polity of monetary union without fiscal union, the build-up and servicing of debt is a highly contentious political issue. The standard trope is of the hard-working and frugal northern European states having to pay for the indolent and indebted southern ones. The reality is of course different and far more nuanced, especially when considering the beneficial effects of a common currency for countries like Germany whose exports would otherwise be hampered by a strong Deutschmark. It seems once again that it is politics that lies behind a lot of the ECB’s current contortions over the euro and its strength.
  • The market is aware that the $1.20 level is the one at which the ECB starts to get a bit itchy about the euro’s strength. Right on cue, when the euro hit $1.20 earlier in September, the ECB’s chief economist Philip Lane went on the tape as follows:

*LANE: ECB DOESN’T TARGET FX RATE, BUT EURO-DOLLAR RATE MATTERS

*ECB’S LANE: WE’VE SEEN A REPRICING IN THE EURO IN RECENT WEEKS

  • The euro immediately started to sell-off, and market expectations of more QE, further rate cuts and the like started to bubble around at the fringes. Even more interestingly, the day before the ECB’s rate decision and press conference, a counter headline hit:

*ECB FORECASTS SAID TO SHOW MORE CONFIDENCE IN ECONOMIC OUTLOOK

  • Cue a rally in the euro as the market reacted to what seemed like a more upbeat tone from the ECB on growth. The actual GDP growth forecasts that Lagarde announced at the press conference don’t really tie-up with this optimistic headline. The central bank now forecasts that 2020 GDP will only fall 8% not 8.7% (whoop), while the forecasts for 2021 (5% vs 5.2% prior) and 2022 (3.2% vs 3.3% prior) are actually lower they were previously.
  • Clearly this second headline was a plant to make it harder for Lagarde to adopt a dovish tone at the press conference and potentially to promise more QE. Who was behind it? The first thing to point out is that the ECB board has been divided and clearly still is, and dissent against previous increases to QE has been voiced most strongly in German quarters. A few days prior to the ECB meeting, Jens Weidmann, head of the Bundesbank, expressed views highly critical of the build- up of debt, and urged for policy normalisation as soon as possible. Some things don’t change.
  • As the euphoria following the European Commission’s announcement of its recovery programme dies down, a harsh reality is re-emerging that in an age when fiscal policy is taking over from monetary policy, the ECB, as the only supra-national central bank in the G10, is uniquely fettered with respect to the political limits to its money-printing. At the same time as Jay Powell intimated in his recent Jackson Hole speech that no level of unemployment is low enough to warrant an undue concern about rising inflation, Christine Lagarde has been forced to say rather lamely that while a strong euro affects inflation expectations, the ECB monitors foreign exchange levels but doesn’t target them.
  • While Lagarde was speaking, the euro rose nearly 1% against the dollar. That was the market’s verdict written large. Ironically, while the British pound initially rose with the euro, it then fell sharply due to Brexit-related angst. If deflation is a trap and inflation therefore the goal, the weaker one’s currency the better. The lesson of the 1930s with respect to leaving the gold standard was the one who devalued first fared the best. This is of course a relative statement, and at the time such policies were acknowledged as ‘beggar-thy-neighbour’ ones. Perhaps in the light Brexit may prove to be a rare blessing as it could provide a big head-start in the race to the bottom. The immediate risk for the euro though is that the ECB has just admitted it can’t weaken it. This is more of a problem with the European banks still mired in bad debt and with sovereign debt pushing up through the 100% of GDP level. It would seem Europe is on the cusp of a debt-deflation trap as its central bank simply lacks the ability to undercut the Fed in terms of dovishness without pushing rates so negative that the banking system collapses.
  • If this is to be the case, it seems strange that the government bonds of those countries which are most indebted and who have suffered most economically in 2020 are still trading so well. The graph below shows the spread of Italian 10yr debt against its German equivalent. After an initial panic sell-off when Lagarde rather inopportunely said that it wasn’t the ECB’s job to control bond yields, the spread rallied (Italy outperforming) as the ECB stepped up QE with an aggressive over-buying of Italian bonds relative to other countries’ debts. It looks for now as though 1.4% is the floor in terms of the spread.

Source: Bloomberg, 11th September 2020.

  • In a low-inflation or an outright deflationary environment, prices fall and with them corporate profits. Debt defaults and insolvencies rise as a consequence of this. This in turn pressurises bank balance sheets, and in the Eurozone, this eventually filters up to the yields at which government bonds trade. While the ECB’s QE and PEPP are keeping a lid on Italian government bonds for now, the question is whether there is appetite not only to maintain this level of commitment, but also to increase it to back the sort of amounts of fiscal stimulus that might in fact get inflation to rise.

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