Notes From Underground

Let me be perfectly clear: THE ECB’s THURSDAY PRESS CONFERENCE WAS DOVISH.

There are many pundits latching on to the idea that the ECB will begin tapering its large-scale asset purchases in October. Maybe the central bank will reduce its monthly buying at the beginning of 2018 but it CERTAINLY won’t start shrinking its balance sheet in the New Year. The ultimate statement from Draghi’s prepared text was that the ECB could increase its purchases if necessary and extend it well beyond December 2017 if inflation continued to remain below the ECB’s self-selected 2% mandate. Importantly, President Draghi did not use the word TRANSITORY in discussing his concerns over subdued inflation. He was stern in noting that the recent reduction in EU inflation may require the ECB to prolong its “substantial monetary accommodation.”

Also, Draghi cited the failure of policy makers to embark on a serious plan of fiscal policy stimulus, making the ECB the only game in town. During the press conference there was a question about the recent strength of the euro. Draghi said the euro strength “had received SOME ATTENTION.” But what reporters didn’t ask about the euro was whether the attention it received was positive or negative. The Germans and Dutch would applaud a strengthening euro while the French, Italians and other peripherals may view the euro’s strength as a negative. President Draghi let it be known that he doesn’t want to see an unwarranted tightening of financial conditions. A stronger euro is definitely one element of tightening financial conditions and as DOVISH as this stance is, the EURO CONTINUED TO RALLY through Friday’s close.

This certainly raises issues about problems with the U.S. dollar.Why is the dollar under selling pressure when both the ECB and the BOJ delivered no changes to their current policies? Even the YEN closed out the week with a BID as it closed above the 200-day moving average for the first time in months. This recent action in the currencies may be due to an unwinding of long dollar positions as so many hedge funds were very BULLISH the U.S. dollar, based on the positive outcomes of a Trump policy that included overhauling the onerous tax code and regulatory rollbacks. BUT, the DOLLAR is being sold while the U.S. equities continue rising, which is causing many investors to doubt the underlying strength of the equity markets.

The European equity markets were under pressure as the EURO rose in value Thursday and Friday, creating a correlation that has been dormant for the first half of the year. But the EU corporations have UBER LOW borrowing costs and access to ECB liquidity through the sale of corporate debt. The immediate response to Draghi’s dovish stance is that all sovereign debt yields dropped dramatically with the Italian bonds declining more than 20 basis points. The German DAX declined the most as it seems Germany’s export juggernaut is deemed to be more vulnerable to a strengthening EURO. But here I offer a caveat–the drop in the DAX may be more related to the news of German authorities examining alleged collusion by the main German auto manufacturers.

There was a Financial Times article on Friday titled, “EU Collusion Probe Threatens German Carmakers Credibility.” It seems that VW, Daimler, Audi and BMW are accused of holding secret technology groups for the purpose of maintaining the lowest costs for innovations. This appears to be a one for all and all for one situation. The German automakers comprise more than 15% of the DAX so be vigilant to the news that could impact the German auto manufacturers.

In concluding about the dovish press conference I note the following items:

1. Draghi gave no date to the withdrawing of QE nor was there any discussions about the technical methods of withdrawing the accommodation;
2. Draghi was asked specifically about the failure of wages to rise in the eurozone. He noted that there has been profound changes since the onset of the financial crisis but was not sure if the changes are STRUCTURAL OR CYCLICAL. Draghi put on his central banker hat and said he believed that low wages were cyclical and will return to NORMAL but is not 100% certain of this. Prudence and patience are needed;
3. In response to a question about the ECB violating the rules of its capital key purchases, Draghi noted the issue was discussed at the ECB meeting but emphasized that the ECB Governing Council has FLEXIBILITY. Because the central bank has been unquestionably successful with its QE PROGRAM so it should be allowed to operate as the Governing Council sees fit (my interpretation);
4. In a very honest statement, Draghi said that the ECB would stick to its 2% inflation MANDATE for changing objectives in mid-stream causes you to lose your credibility and that can be highly destabilizing. Draghi seems to want to stay the course until the 2% inflation target has been achieved. He stressed again that the ECB mandate is price stability, not employment so the ECB is different from the FED. There are pockets of high unemployment but those specific area are not the basis of ECB policy.

I BELIEVE THE GAME FOR DRAGHI remains to BUILD AS LARGE AS BALANCE SHEET AS POSSIBLE IN AN EFFORT TO CREATE THE BASIS FOR A EUROBOND. In maintaining President Draghi’s commitment to “WHATEVER IT TAKES” to preserve the euro and the EU, the ECB will accomplish what the politicians can’t: a harmonized financial system. The FED is different from the ECB and not just because of the dual mandate. The FED represents a single centralized financial authority while the ECB is an amalgam of 19 euro-area countries. The ECB has a printing press but no single fiscal authority to guarantee its debt pile.

This is a complicated balancing act and Draghi has been adept at succeeding with “whatever it takes.” The German elections take place in September so the October ECB meeting can certainly bring a change in policy. Regardless of what takes place in Germany, the other peripheral states are still burdened with huge piles of nonperforming loans and other types of debt. Ending the massive liquidity creation of the world’s main central banks is not going to be an easy task for the BOJ, ECB and FED all have different agendas to serve. As Tip O’Neill would say, ALL POLITICS IS LOCAL.

Tags: DAX, Dovish, ECB, Euro, inflation, Mario Draghi, QE, U.S. Dollar

This entry was posted on July 23, 2017 at 6:43 pm and is filed under Currency, ECB, Europe. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.