What Motivated The Surprise Rate Cut? Concerns Over ECB Image, Deflation And The Euro - And What's So Bad About Lower Prices?
The following is a partial summary of conclusions from our weekly fxempire.com analysts' meeting in which we share thoughts and conclusions about the key lessons we learned from last week's action in global asset markets that matter for the coming week and beyond. These lessons apply to virtually all liquid global asset markets, particularly currencies, equities, commodities and bond markets.
The ECB surprised markets by cutting its benchmark bank refinancing rate from 0.50% to 0.25%.
Everyone believed some kind of easing was coming given all the signs of economic weakness, which had led the ECB to cut its already meager growth forecast for the region. In addition, the coming bank stress tests made things worse. The related negotiations risk their own set of economic headwinds, for example, they cover:
- How to fund (i.e. who pays for or eats losses on) the 50 bln in write-offs
- How to value the hundreds of billions in GIIPS bonds held in EU banks. They're currently ranked as risk free tier one capital. Few seriously believe that, and if that reality is actually recognized, then the recapitalization bill could get a lot bigger
In sum, these risk raising anxiety, and borrowing costs, in the EU.
However most believed the ECB would wait to cut rates until December, because:
- It didn't want to appear to be over-reacting to constantly changing data like the Fed and make the same mistake of sowing confusion in the markets with monthly changes in tone as the Fed did in its recent FOMC statement.
- It was believed the ECB would want to wait to cut until December because it would then have more recent EU GDP data.
So why did it cut now?
It preferred to risk accusations of over-reacting rather than under-reacting. EU consumer price inflation is currently at 0.7%, well below its 2.0% target. It believed that given the available information, there was unacceptable risk of continued deflation, and that if they waited and the inflation rate fell further they'd be open to criticism of risking a Japan like deflationary spiral in the EU. See below for more on the dangers of deflation.
The strength of the EUR since mid-2012 has become an unacceptable burden for the EU. For example, it hinders both exports and job creation by making it harder to attract foreign employers, who must pay staff in increasingly expensive euros.
ECB Reluctant To Begin More Exotic Stimulus Moves - But That's What Markets Want
We also learned that because the ECB elected to cut refi rates and leave its deposit rate unchanged at 0.0%, apparently the ECB is still unwilling to have negative deposit. That could still happen if bank lending to businesses doesn't increase and the EU economy continues to sputter. Similarly, a rate cut was a simpler, less radical step than initiating a US-style bond buying binge, aka QE.
In sum, the ECB concluded that the risks a deflationary low growth spiral had become too great to avoid taking some kind of action and to reduce the strength of the EUR. The rate cut thus makes EU exports more competitive, and eases credit conditions.
The big question now is, if the EU economy continues to struggle, what does the ECB do next? Now that the interest cut option is mostly exhausted and further cuts are unlikely to have a significant impact, the only options left appear to be the more exotic ones with less certain outcomes because we've little long-term experience with them: US - style QE, and negative bank deposit rates.
To counteract the tightening credit conditions and increasing deflation risks, the ECB needs some kind of big new stimulus package. Cutting bank deposit rates isn't enough, especially when impending stress tests encourage banks to horde capital.
Deflation: So Why Is That A Problem?
For the past decades in which most of us grew up, inflation was the fear, and lower prices were considered good. However, steadily falling prices, especially if they happen quickly, can also destroy an economy just like excessive inflation can. Here's how:
- Lower prices mean lower revenues and ultimately, profits, so businesses cut spending on everything from new capital investment to wages and jobs. That can bring further price cuts and a deflationary spiral in which:
- Everyone is poorer
- Cash is worth more, so debtors have a harder time repaying fixed debt payments. That means further spending cuts in an economy where both private and public sector still have too much debt. Also, previously stable debtors now have less income and are more likely to fully or partially default. That further feeds the deflationary spiral and recession/depression.
Given the relative strength of labor unions in the EU, cutting wages and jobs is both harder to do, takes longer, and can cause more unrest than in other regions.
In sum, economies need stable prices, or at least need to avoid prices that change too quickly (in either direction) for everyone to adjust.
Markets Wanted Bold New Stimulus: New LTRO? OMT? Something?
European stocks and other risk asset markets tanked on Thursday, but that wasn't just due to the good US GDP report and its implied risk of an early US QE exit.
They wanted to hear of a big new stimulus program, because the EU has more than just a potential deflationary spiral risk. It's also (still) got a lot of banks that may not survive without a new source of cheap funding, so ultimately EU banking's survival, and thus that of the EU as we know it, may depend on it.
Excess liquidity has been falling and so has lending to business and households. That's not surprising, given both the state of the economy and the coming ECB bank stress tests, which are expected to be serious this time.
As noted in earlier posts, the ECB is running these tests in preparation to take overall responsibility for EU banks, and the ECB does NOT want to get stuck funding someone else's mistakes and capital shortfalls. These are currently estimated at $50 bln, and that's with the polite fiction that all sovereign bonds (GIIPS too) are risk free tier one quality capital. Imagine what happens to that $50 bln figure if that assumption comes under discussion.
Unless the weaker GIIPS banks get a new cheap source of funding, they may not be able to keep buying their governments' dubious debt. Somebody needs to do that, or their yields will soar, their value will drop, and suddenly EU banks hold hundreds of billions or more in bad bonds.
Oh, and there won't be many left to buy GIIPS sovereign bonds, so they'll be in trouble too.
Just keep this in mind the next time you think it's safe to invest in the EU, and that European stocks are bargains.
Fed, ECB Slowly Heading In Opposite Directions
The operative word here is slowly. As we note in our discussion of what we learned about the fed's likely taper timing here, we don't think the fed is tapering as quickly as many think. Similarly, because the ECB has already cut rates, it is less likely to do much more in the near future.
The ECB's overall bias is towards easing, and the Fed's to tightening. The gap between their benchmark rates has shrunk, and likely will continue to do so, although progress may be neither straight nor steady.
Still, for the coming week, the bias is for continued downtrend in the EURUSD, and the 15 month uptrend intermediate term uptrend looks to be at risk, though it has some strong multi-layered support to penetrate before it breaks.
Thus while we expect the EURUSD to test support around 1.33, or even down to a bit below 1.3250, we don't anticipate a further drop in the near future, given the multi-layered support around 1.3250, (see daily EURUSD chart below) barring new fundamentals.
Support points at this level include:
- The 200 Day EMA (purple)
- The 15 month uptrend line (GOLD)
- The 38.2% Fibonacci retracement of the prior downtrend from mid-2011-2012
Meanwhile expect the EUR to show weakness against its other counterparts, and the USD to show some strength.
For those thinking longer term, Citibank sees a 2-3 year rally in the USD index. See here for details.
Disclaimer: The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.