ECB: Sins of omission

Published on 04-12-2015 12:10:35

The sharp declines in European markets after the ECB’s policy announcements show the dangers of talking the talk without following through. If you talk extensively about “size, composition and duration” – and then go on to highlight duration as the primary monetary policy change, then markets expecting fireworks will be certain to be disappointed. For the crowds of investors conditioned to push up equity prices and go short the currency on QE announcement days, size matters.

The sharp declines in European markets after the ECB’s policy announcements show the dangers of talking the talk without following through. If you talk extensively about “size, composition and duration” – and then go on to highlight duration as the primary monetary policy change, then markets expecting fireworks will be certain to be disappointed. For the crowds of investors conditioned to push up equity prices and go short the currency on QE announcement days, size matters.

We have highlighted the policy divergence between the US Fed, seemingly on course to raise US rates come what may and the ECB which remains much more focused on the risks emanating from a challenging external environment, notably in emerging markets.

Exhibit 1: Largest daily move in euro during 2015. Source: Datastream

Paradoxically, the near-term momentum in the Eurozone has in fact been more encouraging than in the US. But yesterday’s ECB policy decisions and commentary considerably narrow the policy gap between the two central banks. Unsurprisingly it was the strongest days of the year for the euro against the dollar, against a weight of expectations that the euro would continue to weaken into the end of the year, Exhibit 1.

The ECB will not have wanted to jolt markets in this way and may have been surprised how markets largely ignored the third component of the policy package – which is to re-invest any principal amounts received from securities purchased under QE program, thus ensuring the ECB’s balance sheet will monotonically increase at the rate of the additional monthly purchases rather than rolling off by default. There may be a difference in perspective between policymakers and investors here; academic arguments may suggest the stock of bonds held by central banks are relevant in terms of the economic effect of QE programs. However such theories tend to be discounted by traders who know the marginal demand for a security which will have the greater impact on price.

That said, the reinvestment of principal will lead to a greater gross amount of ECB purchases over time and perhaps the day’s market reaction would have been softer had this been quantified by Draghi immediately, rather than a day later at an event in New York, as an additional EUR 680bn of ECB QE by 2019.

We are not sure why, having promised so recently to be focused on the external risks to the Eurozone economy the ECB was willing to disappoint the markets in this way. The excuse given by Vítor Constâncio, vice-president of the ECB, that markets had got ahead of themselves does not really fit with Draghi’s press conference comments that staff forecasts for inflation and growth included developments in money markets which followed the pre-announcement of these policy changes at October’s meeting. Embedding market expectations into projections yet later stating that they were unrealistic is unintuitive to say the least.

Unsurprisingly the euro is sharply higher against the dollar post-announcement, as speculative short positions expecting a big policy move are unwound. Finally, while the ECB claims not to target the exchange rate, the rapid depreciation of the euro since October may have given them pause to consider whether they were at risk of causing disorderly FX volatility, with the US Fed remaining highly likely to raise rates at its next meeting.

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