In the ECB press conference held today in Malta, the market heard what they wanted to hear and settled in on the idea that Draghi was all set to increase the QE program and/or use the tool of negative interest rates to bring inflation up to its mandated level of 2 percent. The EURO dropped more than two percent after the Draghi press conference began as investors believed that the ECB was intent on increasing its asset purchases by the December meeting. I listened to the entire press conference but was reticent to draw that conclusion. The markets’ response to the possibility of any enhanced ECB actions poses more questions than the pricing action resolved:
1. It made perfect sense that the European equity markets rallied in dramatic fashion as the inference of QE would lead to a weaker currency, lower interest rates and increased liquidity sloshing around the European financial system. The German DAX rallied a powerful 3.2% amid the recent problems of VW, increased inflow of refugees and questions about Deutsche Bank ‘s financial health were cast aside in the cheers for the future possibility of increased QE from the ECB. But the rally in all GLOBAL EQUITY MARKETS was far more difficult to comprehend. The U.S. equities rallied in conjunction with the DAX and CAC but I have to ask the obvious question: All the recent earnings misses in the U.S. markets have purportedly been BLAMED on DOLLAR STRENGTH so on a day where the DOLLAR rallied more than 2 percent, why did the equity markets shrugged off the dollar’s strength in favor of the LIQUIDITY ENHANCEMENT?
If the DOLLAR continues to strengthen it should certainly keep the FED on hold as Chair Yellen noted the strong dollar as a headwind to economic growth. The NIKKEI INDEX trading on the CME platform also rallied with the DAX and SPOOS gaining almost 2 percent. Watch the Nikkei tonight to see if the Japanese stocks can shrug off the strength of the YEN versus the EURO for the EUR/YEN cross dropped 134 from 136, below the 200-day moving average of 134.55 heading into Friday’s weekly settlement. The BOJ meets next week and I insist that BOJ Governor Kuroda would hold the line at the central bank’s current level of QE. But after Draghi’s “verbal intervention” today the Japanese may be forced to respond with some action. I am skeptical that Kuroda will upset China by weakening the YEN but the euro/yen level is a concern for the Japanese exporters.
2. Another question: Why is it when the Chinese yuan depreciates 2.5 percent in response to PBOC dollar purchases is that intervention challenged by various sovereign nations? But when President Draghi “jawbones” the EURO lower by more than 2% that’s just standard central bank policy and applauded by financial markets? The global financial markets are in a very unstable and fragile state as central banks frequently manipulate interest rates and currency levels. Mario Draghi noted several times in his press conference answers that the level of the EURO was not a policy target of the ECB: “The exchange rate is not a target for the ECB. Never has been and is not now, but it is crucial for price stability and for growth.”
A weaker EURO does help German exporters price more competitively against the world but does NOTHING to make the other European nations more competitive with Germany. Yes, increased German exports may lead to increased manufacturing if German capacity becomes strained but that depends of the level of wages in the peripheral nations. And, as Draghi maintained, the biggest threat for global economic growth is the slowdown in the Chinese and other large emerging market economies. So the Europeans will be dealing with global excess capacity, which weighs heavily on the high-wage countries of France, Spain and Italy.
Will the FED find some of the Draghi arguments compelling enough to keep from raising interest rates or will Chair Yellen come to the aid of her fellow central banker and raise rates and drive the DOLLAR even higher (but not below the levels of the EURO seen in March 2015–1.05 to the dollar). On an annualized basis, Yellen could rationalize that she has “room to move.” But I caution that the Draghi verbal actions have made the global financial landscape more difficult for politically sensitive central banks.
3. At the ZERO BOUND all the actions of the world’s central banks are much more sensitive to political oversight for policy makers become impatient as economies fail to react quick enough to ultra-low rates. We just saw it in Canada as the anti-austerity Liberal party recorded a surprising victory that was not predicted by the polls. Larry Summers is pounding the table for increased fiscal stimulus to counteract the secular stagnation that ZIRP fails to resolve. In fact, President Draghi challenged Eurocrats and politicians to do more to structurally improve the European economies. This was a call for fiscal stimulus via infrastructure projects and enhanced government spending.
Draghi mentioned the idea of structural enhancement several times in the press conference, even invoking the quote from U.S. Senator Charles Schumer: The ECB and asset purchases should not be the ONLY GAME IN TOWN. It was Draghi’s call for fiscal stimulus that was a direct shot fired at the MERCHANTS OF AUSTERITY residing in Berlin. The ECB has had a great cyclical impact on the European economies but now it is time for the individual governments to step up and provide more firepower. The problem for Europe is the Maastricht Treaty calls for strict rules on government deficits and Germany is the only major EU economy meeting the strictures of the TREATY. It will take a major policy shift by the Germans to allow for easing of the rules on fiscal policy.
Currently, Chancellor Merkel is suffering a fall in her political standing as many Germans are angry about the massive inflow of refugees. The Germans are also upset over the ultra-low interest rates they are receiving on their vast savings. The continued unease about Germany being the financier for the debtors of the EU is pushing the right-wing AFD party higher in the polls and the guardian of German hard-money, Bundesbank President Jens Weidmann, is a powerful opponent of further QE and fiscal profligacy.
4. The European bond markets had significant rallies today as yields on Italian, Spanish, French and German debt dropped by at least 7 basis points and 12 basis points on the Italian and Spanish notes. The Italian and Spanish two-year yields are at ZERO while the French is NEGATIVE 26 BASIS POINTS and German paper at NEGATIVE 32 BASIS POINTS. The result is that the ECB cannot purchase French or German two-year notes for it is prevented from buying any debt with a yield lower than NEGATIVE 25 BASIS POINTS. Thus the asset pool of eligible sovereign paper is shrinking, leading to increased demand for any eligible debt. The SIGNIFICANT DROP IN SOVEREIGN YIELDS may have been a result of ECB purchases for the ECB has to buy up to EU60 billion of assets and being close to month end the ECB may have been active in the markets. The RALLY in EUROPE succeeded in sending U.S. yields lower as investors were forced to seek relative value. This is another question left to ponder by the market. But regardless the end result was a declaration of war on the RIGID MONETARY POLICIES OF THE GERMANS.