2021: A NIRP Odyssey (Or, ‘Panic’)

Was the Q1 deceleration in eurozone economic activity in fact “transitory” as policymakers would have markets believe?

That sounds like a boring question (and in some respects it is), but in the context of the ECB’s exit strategy from stimulus it’s enormously important.

At the June ECB meeting, Mario Darghi earned plaudits for pulling a dovish rabbit out of a hawkish hat, simultaneously slapping a sell-by date on ECB asset purchases while adding calendar-based forward guidance on rates which, by virtue of the language, effectively telegraphed to markets that an ECB rate hike wouldn’t come until H2 of 2019.

The date-and-state-dependent rate guidance (the “in any case” language applies to rates) was seen as overtly dovish by market participants and the “at least through the summer of 2019” stipulation on the first hike effectively makes it impossible for anyone to bet on a more hawkish outcome between now and then, no matter what the data says.

All of that catalyzed a sharp drop in the euro (and a concurrent rally in European equities) when it was announced last month and it effectively allowed the ECB to acknowledge the political risk inherent in Italy’s new populist government and also the burgeoning risk from the trade war while still claiming to have taken the first tentative steps towards normalization.

The problem, as ever, is that in the event the deceleration in eurozone economic activity proves to be something other than transitory, the ECB risks “quantitative failure” or, more simply, bumping up against the next downturn with no room to cut rates and no room on the balance sheet.

This makes the threat of a trade war all the more worrisome. If the eurozone recovery is faltering, a hit to global growth from trade tensions could exacerbate the situation.

In reiterating their bullish commodities call this week, Goldman suggested that things are turning around in Europe on the economic front and indeed, the pickup in German industrial production in May (reported on Friday morning) was welcome news on that front.

Apparently, ECB policymakers are now concerned that the market is pricing in too much dovishness after the June decision.

“Some European Central Bank policy makers are uneasy that investors aren’t betting on an interest-rate hike until December 2019,” Bloomberg wrote on Thursday, citing the ubiquitous “people familiar with the matter” who said “a move in September or October next year is in the cards.”

Given the trade backdrop, the still simmering political angst in Germany and the recalcitrant Italian government, it’s clearly impossible for policymakers to say definitively that the environment will warrant rate hikes next year, especially in the event the wind down of APP ends up tightening financial conditions on its own (the reinvestment flows will be there, and apparently they’re going to employ a European version of Operation Twist, but the potential for the end of QE to undercut markets can’t be completely discounted).

Just to give you an idea of why Friday’s IP data from Germany was critical, consider this from Credit Suisse (from a note dated July 3):

For global growth to stay strong in the second half of 2018, European growth must improve. At the end of last year European business surveys hit multi- decade highs and IP momentum reached 7%. Such growth was unsustainable but the abruptness of the slowdown has been extreme (Figure 4).

After Europe’s cliff-like divergence in Q1, broad signs of a Q2 rebound did not emerge, contrary to our expectations. Whether we should “give up” on European growth is a central question now, which we try to answer by addressing what went wrong in the first place.

Credit Suisse’s analysis is lengthy, but the overarching points is to discuss the reasons behind a sharp drop in the bank’s risk appetite measures which have fallen into “panic” territory of late.

While they note that “trade disputes, the Italian budget, Fed tightening, and emerging market turbulence are contending to be the main driver of this risk appetite slump,” growth deceleration has played a role as well.

“European data in particular have disappointed,” the bank’s James Sweeney points out, before exploring the issue as excerpted above.

Again, I don’t want to delve too deeply into the specifics here, rather, the point is simply to say that the ECB is now at pains to explain to a skeptical market why the language in the June statement is more likely to mean hikes start in September or October of next year as opposed to December and beyond.

And “in any case” (to employ the Draghi vernacular), market pricing doesn’t see an exit from negative rates for the ECB until damn near 2021:

Here’s BofAML’s Ioannis Angelakis and Barnaby Martin:

The macro backdrop even though remains positive; it shows significant signs of fatigue. Trade wars, Italian political risks and a slowdown in macro indicators justify a less rosy outlook for credit markets going forward. With PMIs in Italy, Spain and France at ~53 (reading below 50 indicate recession, chart 3) and core inflation only recovering very slowly (chart 2), the risk is that the ECB deliver a first rate hike later than September next year. Note that the rates market price that the ECB will deliver 40bp of cumulative hikes well into the second half of 2020, more than two years from now.

It goes without saying (or at least it should) that if they’re still mired in NIRP at the end of 2020, it is highly likely that they’ll be forced to confront the next downturn with rates still sitting at the lower bound.

What comes next is anyone’s guess and on that note, I’ll leave you with one such “guess” from BNP:

Let’s turn to the eurozone and the challenges it may face if a recession hits, where we assume this is US-led. Global trade growth would of course suffer, which would hit the open eurozone economy hard, leading to lower investment and employment.

The problem could become more severe if the euro were to appreciate on the foreign exchanges. While the dollar might rise in a risk-off scenario against emerging market currencies and commodity exporters, there is a good chance that the JPY, CHF and EUR would be seen as “safe havens”, at least to start with. Given the large outflows from the eurozone in recent years and the tendency for funds to flock home in a crisis, the EUR could appreciate, hitting activity and dampening inflation. A return to negative rates would be likely in our view, though will -40bp be a deep enough cut? We doubt it.

This is because the last two cycles have seen a eurozone output gap of 2-2½% of GDP open up, according to the IMF. A repeat from current levels (where the output gap is close to zero) would require cuts in rates of 1% to 1¼%, according to the Taylor rule. Moreover, if experience of the great recession and the euro crisis is a guide then core inflation might fall by 1% or so, requiring, according to the Taylor rule, cuts of another 150bp. Thus a recession could require rates to be cut to -250bp. This hardly looks feasible.

A return to QE would look all but inevitable, though for several countries ECB holdings of bonds are close to the 30% limit the ECB has set itself. There is a high probability this limit would be lifted — maybe as far as 50%. Along the way, legal challenges to the ECB breaking the monetary financing rule would be likely, even more so if the 50% barrier were crossed. Purchases of other assets would come into question, as the ECB’s Mr CÅ“uré has suggested.