Sunday, August 5, 2012

The ECB and the Fed: don't be disappointed

Lack of action from both the Fed and the ECB this week was no real surprise.   More action from the Fed is still not certain and it was simply too soon for the ECB to act.  We are still optimistic of something meaningful from the ECB, but QE3 is not a done deal yet.

Disappointment the ECB didn’t act is misplaced.  Any action taken by the ECB needs to be in conjunction with politicians and use the financial resources that have already been put in place.  Furthermore, there is still some scepticism the ECB should be doing anything at all, especially from the Bundesbank.  That means it’s going to take a bit of time to get the plan in place.   Furthermore, the ECB can't solve Europe's debt crisis, but it can assist in relieving market tensions that enable continued progress towards a full solution.  After his comments in London where he promised action that would be enough, the challenge for Draghi last week was to give the market confidence that a plan was being developed.  I think he did that.

Draghi’s main point was that "risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner".  The fundamentals are the same as they always were: fiscal consolidation and structural economic reform.  However, there is still the problem of financial tension and instability as progress towards those broader objectives unfolds over time. 

The financial tension is indicated by unsustainably high bond yields in Spain and Italy.  Draghi has indicated the ECB will work with governments to buy bonds in sufficient quantities to bring yields back to more sustainable levels.  That will mean countries under stress such as Spain and Italy applying to the EFSF for help in the first instance.  That would then result in the EFSF purchasing bonds in the primary market and the ECB in the secondary market.   EFSF assistance comes with conditions and the signing of a formal Memorandum of Understanding with appropriate setting of fiscal and structural reform targets and monitoring of the achievement of those targets.  That ties ECB assistance to progress on more fundamental issues.

Another important comment was "The Governing Council, within its mandate to maintain price stability over the medium-term and in observing its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective".  Setting bond purchases in the context of maintaining price stability is directed primarily at Bundesbank concerns that the ECB is stepping outside its mandate.

Draghi also stated that concerns of private investors about seniority will be addressed.  That's very positive for private bondholders.  He also said that the ECB may consider undertaking further non-standard monetary measures to repair monetary policy transmission.  It was interesting that Draghi said no decision had been made on whether bond purchases would be sterilized, opening the door to quantitative easing.

This is all very positive.  It's not the solution to the euro debt crisis, but it's a mechanism that may allow a reduction in market tension while the real solution of fiscal consolidation and structural reform plays out.

Market disappointment the Fed didn’t act this week was also misplaced.  The Fed has made it abundantly clear they are prepared to do more in light of the recent deceleration in economic momentum.  However, they don’t think things are yet bad enough to act.  I think that’s actually good news (once again declaring my scepticism that the Fed can do much more to influence real economy outcomes in any meaningful way).

Whether they go ahead and do more will be dependent on how data plays out between now and the next Fed meeting mid-September.  In the interim we also get Bernanke’s Jackson Hole speech at the end of this month.  That speech will no doubt be analysed by Fed-watchers word-by-word.

Payrolls data will be especially critical.  The rally in the US equity market following the release of July payrolls data on Friday meant one of two things; either payrolls had surprised on the upside, or payrolls surprised on the downside and more QE was a done deal.  Thankfully if was the former and therefore a vastly better story than the alternative.

Payrolls expanded 163k in July, more than the average market expectation of 100k.  Private payrolls rose 172k with the manufacturing sector posting a gain of 25k.  The unemployment rate rose to 8.3% on the back of the drop in employment in the separate household survey which was payback for a larger than expected gain in May.
That level of payrolls growth is better than the last few months, but still soft and well short of a robust recovery.  Other recent data has been mixed.  The US manufacturing PMI remained under 50 for a second consecutive month while the services PMI rose to 52.6 in July.  Personal incomes rose 0.5% in June, but spending was flat.  Perhaps Americans are saving their pennies for the holidays?  Also the Case-Schiller house price index rose 0.9% in May, but still down on year ago levels.

On balance we think the data points to a further slowdown in US GDP growth in the third quarter: we’ve got a seasonally adjusted annual rate of 1.2% pencilled in, down from 1.5% in Q2.  But that doesn’t make further Fed action a done deal.  Watch this space.