PMC Weekly Review - June 22, 2018

A Macro View: Dove Stays Alive: ECB Continues Policy, Furthering the Transatlantic Divergence

Monetary policy is now in the driver’s seat in global markets, dethroning the much-publicized Trump-Kim summit, which was followed by muted reaction from the markets. Although the extent of success of the North Korea—United States summit on June 12 is still being debated, the Federal Reserve’s (Fed) June 13 policy announcement, followed by the European Central Bank’s (ECB) on June 14, had an
immediate impact on currencies, rates, and equities. Whereas the Fed raised the rates as expected and maintained its hawkish policy tone, the ECB delivered the sucker punch, continuing its dovish stance and giving a fair indication to the market that the transatlantic policy divergence is here to stay, and might even continue for the foreseeable future.

The ECB’s Governing Council session, held in Riga, Latvia, made the following monetary policy decisions after assessing the broader macro-economic conditions:

  • Post September 2018, the current asset purchase program (APP) will be halved to €15 billion until it ends in December 2018, subject to the incoming data confirming its medium-term inflation outlook.
  • Principal payments from maturing securities will be reinvested for an extended period of time.
  • Key interest rates main refinancing operations, marginal lending facility, and the deposit facility will remain unchanged at 0.00%, 0.25%, and -0.40%, respectively, with no interest rate hikes foreseen through the summer of 2019.

This dovish tone took the market by surprise, as the consensus expectation was for a policy rate normalization (first rate hike) by June 2019. The euro (which was clawing its way back after the pounding it received in May from escalating Italian political risk), retreated sharply, hitting close to a one-year low following Mario Draghi’s June 19 reinforcing statement. German, French, Spanish, and Italian
bonds rallied along with European equity indices, and the Stoxx Europe 600 surged to its highest level in two months. The immediate impact of the ECB’s stance was seen across the Atlantic as well, where the S&P 500 Index gained 0.25% and the NASDAQ Index added 0.85%.

The ECB’s policy announcement was accompanied by a softer outlook for the region’s economic expansion. Mediocre economic data from Europe, resulting in the global investment narrative for most investors shifting from “synchronized growth” in 2017 to “decoupling” this year, also has prompted the ECB to temper its growth estimates. Gross Domestic Product (GDP) forecasts were reduced from 2.4% to 2.1% for the year. Modest growth also is expected in 2019 and 2020 at 1.9% and 1.7%, respectively. In addition, the ECB forecasts a headline price growth of 1.7% for this year, which is expected to sustain in 2019 and 2020. Although these weak growth estimates factor in worries over protectionism and tariffs, Mario Draghi considers the European economy to be strong enough to overcome these risks. In a speech in Sintra, Portugal on June 19, he reemphasized that the ECB will take its time to normalize rates, and the decision will be data dependent. He reiterated caution on the potential risks of increased global protectionism, rising oil prices, and heightened financial market volatility.

This week, trade and tariffs rhetoric has snatched central banks from center stage, and any escalation should anchor long-term yields for safe-haven assets like US Treasurys and German Bunds. In the US, the flat yield curve is creating some uneasiness, as a negative slope has a history of being a leading indicator of recession. Given its historical implications, an inverted curve could create some dissidents among Fed officials. At the ECB conference on June 20 in Sintra, the Fed, ECB, Bank of Japan (BoJ), and the Reserve Bank of Australia RBA chiefs reemphasized threats to the global economy from escalating trade tensions. Both transatlantic central banks expect economic data to drive their policy decisions going forward, and how the identified risks will percolate in the economic numbers remains to be seen.

Although dampening numbers might lead to a pause, given the clear indications provided by both the Fed chair and ECB President, policy divergence might continue as a key economic theme for money managers in 2018 and maybe in 2019. Global investors must be cognizant of potential escalation of macro risks, which is bound to result in elevated volatility (most risks are beyond the central banks’ control), as both the economy and markets are in their late cycle. The hope is that the prevailing tariff disputes will not escalate into full-blown trade wars, which could derail the global growth engine and distort monetary policies. Neither investors nor central banks seem to like uncertainty, and the central banks cannot afford to make policy mistakes at this juncture. As the IMF’s chief, Christine Lagarde, stated “The clouds on the horizon …are getting darker by the day…”1

Parina Sharma, Investment Analyst, PMC Research - India
Navaneeth Krishnan, Investment Analyst, PMC Research - India​


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