That was the week that was – Sunday March 13, 2016

Markets

It seemed like a highly volatile week in markets, but was it really? The high drama of the ECB monetary policy decision, press conference and post-conference damage-control turned out to be not so noticeable on a longer term view, at least in the US.

There is a lot of information in price moves to unexpected news, but perspective is also important to use markets to see where the economy is heading in the medium term.

Take currencies: the Euro rose sharply over the week, almost all of it during the botched Draghi press conference (as in the left hand chart below). But “sharply” is a tricky word to use. While it looked a big move on the day, the longer term move down in the Euro remained very much intact (the right hand chart below).

The broader US$ index is still staying strong. The big move up in the US$ versus all major free floating currencies following the monetary tightening at the end of QE3 from mid-2014 is also still very much intact. I expect the US$ to remain strong vs the Euro, though it may not strengthen a lot further given US political uncertainties (aka “Trump”).

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The S&P500 was more or less flat on the week. The “data” in the form of surveys was quite bad and did some damage to equities earlier in the week, only to be rescued by the currency weakness vs the Euro and the European equities rally on Friday.

The yield curve steepened slightly over the week. The unexpectedly bad economic news from surveys (see below) had naturally flattened it but that was more than offset by a sharp rise in longer term yields at the end of the week. While the 12m benchmark yield stayed largely flat, the 10yr yield jumped 15 basis points from the Tuesday lows of 183bps to an end of the week high of 198bps. The ECB measures really were well taken by bond markets, especially in the US.

The CME’s FOMC decision market actually did see a bringing forward of the next rate rise possibly by July, and more than likely by September. These moves are probably in response to the inflation “data” from the previous week.

Topic of the week: Europe again!

The ECB monetary policy decision and following press conference was a remarkable illustration of the power of monetary policy. “The future is now” for markets. All financial asset prices are net present values of future revenues, either income streams, capital gains or both.

In periods of stable nominal growth expectations these do not move markets wholesale. When monetary policy is uncertain, news about policy can have big impacts.

We had expected Draghi to manage to beat market expectations with the breadth and depth of his policy changes, and he did.

The Germanic inflation hawks who had been quiet in the run up to the meeting had indeed backed down in the light of weaker German economic data and financial markets. The February collapse in European bank shares and bond prices including, or especially, those of the iconic Deutsche Bank must have scared them.

Unfortunately, these hawks (I speculate) had somehow managed to force Draghi to agree that more rate cuts were unlikely and that the measures would work. Or maybe the banks complaints about the impact of negative rates on their profitability going forward had hit home, and the central bank had agreed to not cut rates any more.

These, perhaps tacit, agreements with the hawks and/or banks, did not appear in the statement but the issue was certainly playing on Draghi’s mind. During the press conference he gave his fatal answer that even more negative rates were unlikely. This played to the doom-mongering chorus of inflation hawks and general misery-guts who think monetary policy can run out of ammo. They started buying the Euro instead of selling it and the statement-induced rally turned around.

Of course, monetary policy can never run out of ammo. Those doom-mongers used to say that rates couldn’t go negative or that QE would lead to hyperinflation. They have been proved wrong and wrong again. They get support for their views from the horribly slow pace of the recovery, but the reason for that is very clear. The ECB inflation ceiling heavily offsets the benefits of the official policy instruments being used.

Every reiteration of the ceiling is like a death-knell to the progress coming from those physical instruments of monetary policy. Sadly, it ignores the fact that the most powerful instrument by far is expectations management.

The rally in the Euro paused for a bit during the conference as Draghi seemed at one point to be endorsing level targeting of prices in response to a question (the only good question in the entire conference) as to whether the inflation target was symmetrical.

He seemed to say “yes” but his reply was too short and open to interpretation. He also seemed to take another question as an invitation to discuss helicopter money. It is largely a silly idea, or rather empty of content, as all monetary easing is helicopter money. He first said the ECB had not considered it or given it any thought, that is just a question for academics, before he did in fact give his thoughts.

Then, towards the end of the conference he was handed a piece of paper that he read out. It reiterated in a more concrete version the tacit agreement about no more rate cuts being likely, “unless the facts” changed. The “facts” turning out to be the ECB’s forecasts, I think. But his answer was unclear, and why was he talking about it anyway? The market continued to buy the Euro and stocks fell back.

Overnight and the next day the damage limitation exercise got going properly and stocks rallied strongly. A key part was his deputy’s Vítor Constâncio´s blogpost asserting that monetary policy would not run out of ammo even if perhaps there were practical limits to negative interest rates.

Interestingly, the Euro stayed flat, so the equity rally may also have been driven by relief about the measures to underpin the banking sector.

The bottom line is that Euro base money growth will continue showing its strong upward trend for many more quarters. It will work, but gradually.

The ECB still has a long way to go to catch up with the money creation done by the Fed, the BoE and the BoJ. That they have all now faltered is a bad thing, but at least getting up to their levels is a good thing.

Far better would be expectations management via changing the target from an inflation ceiling to NGDP Level Targeting, or at least price level-targeting. That is some way off, but perhaps not so far off as all that.

More and better questions from the public via their “representatives” among the journalists at the press conference or their real representatives in the European Parliament would be a good start.

Data

As expected the GDPnow 1Q16 forecast moved little as there was little data released to move their model. It has the January data mostly in it already and is largely waiting for February. It doesn’t respond too much to surveys, but perhaps it should. Two surveys released on Tuesday were both quite interesting as both reflect broader conditions and both were unexpectedly negative.

The Fed’s Labour Market Conditions Index showed a large drop following on the steps of a negative reading in January.

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The NFIB Small Business Optimism index showed a drop on an already weak January.

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Next week we do see the start of the February official data cycle with the release of retail sales figures on Tuesday, Industrial production, the CPI and housing starts on Wednesday.

The Fed itself will be the centre of attention with its two-day meeting this week. Who can say what they will do, given their recent flip-flopping track record.

They have said they are data-driven, but raised rates in December against the data. And then backtracked when the financial markets responded badly to Fischer’s “four more hikes” interview.

The “data” they say they watch, core PCEPI, has turned out in a way that should bias them to another rate rise. Core CPI, that they say they don’t officially watch was also higher than expected.

Other data that they sometimes do, sometimes don’t, look at was less strong, like wage growth. Jobs numbers were better than expected.

It’s such a confusing world for them. They should of course look at nominal growth expectations. But proxies for nominal growth expectations are poor. Our forecast is hovering just above 3% and likely to go lower. As the chart shows, actual NGDP growth has been on a downtrend since mid-2014.

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