Recap 2014-11-21: Thoughts On Draghi’s Speech, PBoC cut, Weekly charts

Commentary:

On Draghi’s Speech:

So the market understood Draghi’s speech as a green light for sovereign QE. It was actually a clever speech – Draghi actually never used the word ‘sovereign,’ and in fact the only references to purchases of sovereign bonds were discussions of the Fed and BoJ QE programs. On the face of it, it will be very difficult for the Bundesbank to criticize Draghi for the speech, even though he seems to be clearly signaling that the ECB is getting closer to such a program.

The market reaction is pretty understandable – after all, the ECB is unambiguously missing its mandate by a large margin. But there are a number of nuances here. Given the commentary I read today, it seems that people are making a number of assumptions that are on shaky ground. Assumptions seem to include:

• EU QE will be like US or Japanese QE. A major difference is simply that there is a much lower limit for the ECB’s balance sheet size. It’s not clear what that limit is, and they are probably quite far from it, but the limit nevertheless exists. One reason the BoJ program has worked as well as it has is because there is theoretically no limit for the BoJ’s balance sheet – that’s not the case for the ECB.
• Central Bank Balance sheet increase = automatic currency depreciation. The best way to explore this assumption is via the chart below, which shows EURUSD vs the relative central bank balance sheets as a percentage of GDP. It should be clear that the relationship is weak and time varying. In addition – current currency levels already discount a surge in the ECB balance sheet. In fact, if the ECB wants to get its relative balance sheet position vs the Fed to the same level as mid 2012, they will have to increase their balance sheet to 4trn Euros – twice as much as Draghi’s target size. It is of course quite possible, if not probable that the ECB balance sheet gets to that size. What I want to point out here is that it seems to be already discounted by the price.
  

• QE results will be similar across countries A very key point is that there needs to be a mechanism to convert the printed reserves into expenditures. In Japan, the government did that via large budget deficits. In the US, that was actually done by the banks – C&I loan growth was quite strong despite the fiscal contraction at the Federal level. There is no such mechanism in Europe.

With respect to the surprise PBoC cut today – we should be careful not to interpret it as much of an ease. The cut is simply following the decline in inflation over the past few quarters. Note that the REAL 1y lending rate remains at the highest level since late 2009:

Finally – a couple interesting weekly charts:

The S&P is back near the rising uptrend line stretching back to 2010 on the log chart:

And quite interestingly, WTI seems to be starting its bottoming process, with the first weekly up close (though barely) since Sept. Falling oil prices have been a major source of support for the long USD trade, especially vs the commodity currencies, so this is probably a good time to reassess.

Notable:

• Draghi’s speech at the European Bank Congress:

1. a channel I particularly want to focus on is the risk that a too prolonged period of low inflation becomes embedded in inflation expectations. The firm anchoring of inflation expectations is critical under any circumstances, as it ensures that temporary movements in inflation do not feed into wages and prices and hence become permanent. But it is even more critical in the circumstances we face today.
2. This is because if inflation expectations fall, the real interest rate rises, which is the interest rate that matters most for investment decisions. And because nominal short-term rates in the euro area have already reached the effective lower bound, they cannot be adjusted downwards further to compensate for this. In other words, any de-anchoring of expectations would cause an effective monetary tightening – the exact opposite of what we want to see.
3. Longer-term indicators are on the whole within a range that we consider consistent with price stability. Over shorter horizons, however, indicators have been declining to levels that I would deem excessively low. Survey-based measures of inflation expectations have generally been more stable, but the latest Survey of Professional Forecasters also indicates some decline – and at all horizons.
4. there is evidence that both the various Large Scale Asset Purchase programmes of the Fed as well as the Bank of Japan’s Quantitative and Qualitative Easing programme led to a significant depreciation of their respective exchange rates, even in a situation in which long-term yields were already very low, as in Japan.
5. through these portfolio balance effects the central bank can also expect to have a strong signalling effect. They signal that we will use all means available to us, within our mandate, to return inflation towards our objective – and without any undue delay. This in turn helps anchor inflation expectations and thereby lower real interest rates, boosting activity and inflation. This is also a channel that was operative in the US and Japan.
6. Let me underline however that contingent on outcomes, we are committed to recalibrate the size, pace and composition of our purchases as necessary to deliver our mandate.
7. it is essential to bring back inflation to target and without delay. Monetary policy can and will do its part to achieve this. But it is also clear that, as monetary policy works on the demand side of the economy, other policies can assist in this process – or at least not counteract it.
8. This means that the aggregate fiscal stance of the euro area has to be consistent with our position in the cycle. And it means that this fiscal stance must be achieved in a confidence-enhancing way – that is, consistent with the fiscal governance framework – otherwise lack of confidence will undermine investment and offset the positive effects of fiscal policy on demand.
9. we will continue to meet our responsibility – we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us.
10. If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialise, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases.

ANZ: China’s central bank announced tonight that it would cut the policy rates, effective from tomorrow morning (22 November 2014). There are two features of this surprising move:

1. this is an asymmetric rate cut. The central bank cut the one-year lending rates by 40bps to 5.6% while cut the one-year deposit rates by 25bps to 2.75%.
2. the PBoC allows the commercial bank to increase the ceiling of deposit rates to 1.2 times of the benchmark interest rates, from 1.1 times previously. PBoC states that this intends to accelerate the interest rate liberalisation reform.

Japan’s finance minister Taro Aso expressed alarm over the rapid decline in the yen. “The pace of the decline in the past week has been too fast.” Koichi Hamada, a key Abe advisor, defended “Abenomics” and said the country’s economic policies were working well; Hamada also called the yen slide a positive and said the economy would benefit from the yen hitting 120.

Canada CPI jumped to 2.4% YoY vs 2.1% exp and 2.0% prev. The core measure also rose to 2.3% vs 2.1% exp and prev.

Upcoming:

• Mon: German IFO, US Markit Services PMI, BoJ Minutes, BoJ Deputy Governor Nakaso speaks
• Tue: Canada Retail Sales, US House Prices, Consumer Confidence
• Wed: UK 3Q GDP, US Durable Goods Orders, Us Jobless Claims, Personal Income, Core PCE, Chicago PMI, Pending Home Sales, AU 3Q Capex
• Thu: US Holiday, German Employment, Consumer Confidence, Japan Employment, CPI, NZ Business Confidence, UK Consumer Confidence