A Huge ECB Meeting Looms Ahead

May 28, 2014

From a euro high of $1.3993 on May 8 when the ECB Governing Council met this week to a low today of $1.3589, the euro has depreciated 2.9%, equivalent to a 3.0% recovery of the dollar against the common European currency.  Never mind that ECB officials for years have preached to markets that they never pre-announce a policy change, for that indeed is what occurred in May.  True, the details of what policy easing steps will be unveiled at the June meeting remain a mystery, and Draghi’s May press conference made stimulus in June contingent upon new price and growth forecasts due then from the ECB staff.  But nobody has been in doubt from May 8 that some concrete action, not just more words, would be unleashed at the June meeting. 

One of the most effective means of distributing the intended stimulus will be euro depreciation.  By dangling the prospect of possible dramatic stimulus to be announced in early June, ECB officials have already achieved some desired results from their intention to ease policy in June.  It’s clearly too early to tell whether a credible package of measures will be delivered.  Disinflationary monetary policy has until now become just as deeply entrenched in Europe as pro-growth Fed policy was in the 1960s and 1970s or, for that matter, the quest for low inflation in Japan prior to Abenomics.  It’s possible that the ECB will announce steps that at first glance will look credible but that will not depress the euro in an enduring way.  The Federal Reserve and U.S. Treasury put together a multi-dimensional dollar rescue plan in November 1978, which included a 100-basis point interest rate hike, which was at the time the biggest such incremental move, and the dollar rebounded around 13% over the ensuing half year.  But follow-up support for the new policy was initially lacking even as inflation continued to crest, and the dollar eventually came under renewed selling pressure in the summer of 1979.  Undertaking some monetary policy changes, even though dramatic, wasn’t sufficient.  The Fed’s image of being soft on inflation had to be convincingly destroyed, and that meant changing personnel (replacing G. William Miller with Paul Volcker as Board Chairman) and a whole new approach to monetary policy, the introduction of quantitative tightening.  Between the start of 1980 and August 1981, the dollar soared 51% against the mark, and that was only the first leg of a multi-year revival.

The Bank of Japan had tried many things, including quantitative easing, without lasting success to stop yen appreciation and general Japanese deflation.  Abenomics presented defined goals for growth in the monetary base and the maturity of the central bank’s bond portfolio, and it promised an open-ended pursuit of stable 2% inflation until the mission is achieved.  Moreover, like the Federal Reserve’s mid-life crisis, it was necessary to put new leadership in charge of Japanese monetary policy in order to convince markets and the public that a real change in policy philosophy had occurred.

So what does this mean for the ECB’s upcoming task.  I think a brand of quantitative stimulus is essential and frankly more important than a negative deposit rate if attitudes about the ECB are to be changed.  There does not seem to be any way to put different personnel at the helm of policy, which makes it all the more important to provide a show of “shock and awe” that points to a willingness at least over the coming two years to accept a much higher probability of getting inflation of 2.5% or higher than of tolerating inflation that remains below 1.5%.  The memory of the hyper-inflations in the early twentieth century has to get purged once and for all.  And there has to be a realization that this will not happen unless the euro embarks on a multi-year journey of depreciation.  It’s very doubtful that this will happen, because the euro area has emerged from recession.  It usually takes a full-blown economic and/or political crisis to prompt a policy leap into the unknown.  A time will come when this happens, but it isn’t now.  At best, Euroland is where the U.S. was in 1978 or Japan in 2001.


Summertime Trading Season

The calendar year divides into three seasons, before the U.S. Memorial Day holiday, the summer, and what’s left of the year after the Labor Day weekend in early September.  Summertime has unique properties that separate it from the other two seasons.  Market participants are coming and going from holiday.  Oftentimes, market depth, breadth and resilience are not as solid.  It’s mistaken to assume that nothing happens of significance in summer.  The dollar’s link to gold was severed in summer.  Both world wars began in summer.  So did some of the most meaningful currency market trends.  And here’s a quirk to keep in mind.  In each of the summer seasons of the past five years (2009 to 2013), the dollar fell on balance in summer against both the euro and yen, although none of those drops exceeded 7.0% in size.


Long-Term Interest Rates

As this summer gets under way, sliding long-term interest rates is perhaps the most attention-getting market story.  The 10-year German bund yield has dropped 31% from 1.95% in late December to 1.34% now.  Britain’s 10-year gilt in the same span is down 16%.  Germany and the U.K. have each experienced stronger economic growth in the first third of 2014 than did the United States where, despite Fed tapering, the 30-year Treasury has fallen to 3.29% from 3.94% and the 10-year Treasury has dropped to 2.44% from 3.00%.  Over five years have passed now since central bank rates in the major advanced economies hit rock-bottom near zero percent, yet analysts still talk about years rather than months or quarters remaining before meaningful normalization occurs.  It remains to be seen if any of these economies would remain in recovery if central banks were at 2-2.5%, let alone at the old normal of 4-5%. 

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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