During the recent period of market volatility the US Fed has in our view successfully re-positioned itself on the doveish end of expectations, both in terms of interest rate and more recently balance sheet policy. The ECB in comparison appears flat-footed, with ECB President Draghi failing to use the opportunity in his press conference last week to emphasise policy flexibility in the event of a downturn. Ironically, the most recent disappointing incoming data is concentrated in the eurozone, rather than the US.
That the US Fed is reportedly (WSJ 25/01/19) considering ending its balance sheet reduction program much earlier than previously anticipated is a remarkable turnaround given Fed Chair Powell’s comments as recently as December that quantitative tightening (QT) was on “autopilot”. Policymakers do not seem to have an especially clear idea of the impact of any reduction in the pace of QT, but may have been spooked by the rapid declines in certain segments of the credit markets during the course of Q4. In particular, leveraged loans and high yield bonds suffered significant losses. In the case of high yield bonds the new issue market briefly shut completely.
By allowing 2019 US rate expectations to fall and also raising expectations of a change to balance sheet policy, the US Fed has clearly reacted to the volatility in capital markets. Since the Fed changed tack, leveraged loan and high yield bond yields have quickly recovered, despite a number of alarm bells rung by well-respected organisations on the excessive growth and declining quality of corporate credit.
Yet as originally noted by the US Fed, incoming economic data for the US has been largely in-line with expectations in recent months. It is in the eurozone where activity appears to be suffering from a sharper softening.
Draghi’s wait-and-see theme during his press conference last week was not unexpected; absent an emergency it is probably easier to move ECB Governing Council opinion on the basis of the next set of economic projections, due in March. Draghi also confirmed there was consensus on the cause of the eurozone slowdown – uncertainty in respect of Brexit and trade, declining China growth, a fading US fiscal stimulus and the specific auto industry issues.
What concerns us however is that there appears to be a split with the Governing Council on the likely persistence of the soft patch in eurozone growth. This split will need to be resolved prior to any decisive action being taken in our view. It is insufficient comfort for investors to hear that the ECB’s state and date dependent forward guidance or reaction function will allow forward rate expectations to move according to the data. Brexit uncertainty alone would in our view justify the application of a precautionary principle, given that eurozone rates have no room to move lower in the event of a deeper downturn.
By March, we expect that the ECB will have given increased consideration to the weak incoming data and the need, or otherwise, of emergency planning to deal with a no-deal Brexit will be clearer. In addition, with the Fed considering adjusting its balance sheet policy, this may have opened the way for other central banks to take a more flexible view of their own balance sheets over coming quarters.
We therefore expect the ECB to do the right thing in the end – which is to adjust policy according to the prevailing economic state. However, the ECB appears to be missing an opportunity to embrace more dynamic policy thinking, as seen at the US Fed recently, which would in our view improve the effectiveness of the current monetary policy mix and reduce the volatility of eurozone markets.