Weekly Economic Commentary | Week of September 1, 2014

posted 9/5/2014 in Investments

Highlights

  • The market is not expecting the ECB to begin QE this week, although other forms of policy support are likely.
  • The data continue to suggest that more aggressive monetary policy from the ECB would have only a muted impact on the Eurozone's real economy unless the fractured banking system can be repaired.
  • Policy divergences among the world's major central banks are likely to intensify in late 2014 and beyond.

Central Bankapalooza

Financial market participants will need to shift quickly out of summer vacation mode, as the week's economic and policy calendar is chock full of key events that could help set the tone for financial markets over the remainder of 2014 and well into 2015. August vehicle sales, the Institute for Supply Management (ISM) Index, and, of course, the monthly employment report for August are all due out this week. Further, no fewer than nine central bank meetings next week could draw significant attention from the markets. In fact, the only major central bank not meeting next week is the Federal Reserve (Fed), although four voting Federal Open Market Committee (FOMC) members are scheduled to speak this week, and the Fed will release its Beige Book as well.

Although none of the nine meetings will likely result in a change in policy, the European Central
Bank (ECB), which is the Eurozone's central bank, is likely to hint that more easing is imminent, and the Bank of Japan (BOJ) is likely to sound dovish as well. On the other end of the policy spectrum, the Bank of England will continue to prepare markets for the start of rate hikes later this year.

What Might ECB Stimulus Look Like, and Is It Already Priced Into the Bond Market?

In August 2014, Eurozone inflation ran at just 0.3% year over year, lurching dangerously toward
deflation and well below the ECB's 2.0% inflation target. Eurozone inflation is a potential trigger for ECB action [ Figure 1]. Expectations around action by the ECB have increased following very dovish remarks by ECB President Mario Draghi at the Fed's recent Jackson Hole monetary policy
conference. The ECB is expected to do one, or a combination, of three things:

  • Cut interest rates further into negative territory;
  • Begin targeted asset-backed securities (ABS) purchases (to stimulate consumer lending); and/or
  • Enact outright quantitative easing (QE) via government bond purchases.

The market is not expecting QE as soon as this week, but ABS purchases are more probable with
estimates varying between 300 and 500 billion euros in purchases, roughly equal to or slightly
smaller than the Fed's second round of QE purchases in 2010-11. European government bond
markets have already done a fair amount of work in pricing in such action, and any further yield
declines are likely to be limited. Significant doubts exist regarding whether ABS purchases would
work, and the ECB would likely have to surprise markets to spark growth expectations and higher
bond yields.


European Financial Transmission Mechanism Still Broken

But even as the ECB mulls another round of monetary stimulus, the fractured European banking
system continues to struggle to provide much-needed capital to the business and household sectors in Europe. Data released last week (August 25-29, 2014) revealed that in July 2014, money supply growth in the Eurozone was up 1.7% from a year ago, but bank lending to the private sector had declined by 3%.

Sizable deterioration in lending occurred in July 2014, with lending levels at the end of July, 14
billion euros below June 2014 level. The data continue to suggest that even if the ECB does embark on more aggressive monetary policy (ABS purchases or outright QE), its impact on the real economy could be muted unless the fractured banking system can be repaired.

Each and every year, we devote many pages in this and other publications to discussing the United States' central bank -- the Fed. We have also written extensively about the Eurozone's central bank, the ECB; China's central bank, the People's Bank of China; and more recently the Bank of Japan (BOJ), Japan's central bank. But what about the other prominent central banks around the globe?

  • Have they been lowering or raising rates?
  • What are their concerns?
  • What indicators do they watch?
  • What are their views of economies beyond their own?

The political independence, as well as the relative transparency, of each of the banks is also of keen interest to market participants. We plan on examining these issues in future editions of the Weekly Economic Commentary.

Figure 3 details 25 central banks, representing 23 of the top 25 economies in the world. These central banks set monetary policy for countries, making up nearly 90% of the world's gross domestic product (GDP). What they do and say matters, even in years where policy is likely to take a back seat to portfolios, as has been the case in 2014. While there is still plenty of uncertainty around likely central bank actions in 2015, many of the world's major central banks will be on the move.

Central bank policies have diverged in 2014. Some banks have cut rates in response to weaker
growth, while others have raised rates to protect their currencies or to guard against rising inflation.

The divergence in central bank policies within the developed world, and between the developed
world and the emerging market economies, has created risks and opportunities across the
investment spectrum -- equities, bonds, commodities, and currencies -- for active managers
investing in many of these regions and asset classes.

Looking ahead, with the Fed likely to outline its exit strategy from QE this fall, the BOE poised to
begin to reduce its QE program, but the ECB and BOJ looking to do more, the policy divergenceamong the world's major central banks is likely to intensify in late 2014 and beyond. 

This will create risks to global economies and financial markets, but opportunities as well. We will continue to monitor what these banks do and say throughout the year, keeping in mind that portfolios are likely to continue to matter more than policy in 2014.

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