Monday, February 15, 2016

ECB Action: The Jedi Tricks Still in Store

So ECB is almost "pre-committed" on some action in the March meeting with all the talks going on. If you are not convinced, remember how Mr. Draghi went out of turn in the last press meeting in January, to remind everyone that the decision to "consider" action in March was an "unanimous".
Since then the stock markets sold off a lot, break-even inflation went downhill (although Euro are inflation was not that much disappointing) and BoJ announced negative interest rate policy, first time in its (rather long) history of monetary stimulus.
But in spite of all these actions and promises from central banks, the response to monetary stimulus is already waning. The equity markets unwound the second round of monetary stimulus from BoJ in months, and the latest round in days in fact. And even with such a strong promise for action from ECB and relatively dovish Fed, you would have made money if you shorted euro rates vs. USD.
The question is what else the central banks are left with. Well, I think it is too early to say they are out of options.
Firstly we still have quantitative easing. It may have some limited effect on markets already under pressure from such measures, like Japan or Euro area, but in places like the US or the UK it is still very much potent. [EDIT] Even in case of the others, QE can still be very impactful, at least on the markets, in case the underlying assets are extended to other asset classes - like bank stocks!
Then the negative interest rates. This is the one I like the least. Firstly it is NOT very clear what it exactly does for the "general level of rates" in the economy. If everyone is super-rational and able to free his or her mind from this weird concept of having to pay to park cash, life can goes on as usual. But that is a lot to ask. Firstly the banks cannot pass on negative interest rates to customers effectively. This harm the banking sector profit in a big way, as we have seen in the large re-rating of banks across markets recently. Plus if your economy is dependent on banking sector lending (as opposed to direct capital market access) this can be a dangerous move. Facing negative interest rates, banks have incentives to either improve bottom line by cutting costs, or reduce lending business altogether - focusing on either best of their clients and/ or riskiest names. This is not bad for big corporates. This is not bad either for riskiest customers. But this is bad for the ones sitting in the middle, which is the vast majority of the small and medium sized business. Besides, negative interest rates are politically unpalatable, especially in election years.
Then we have the yet un-tested weapon: the ultimate Jedi mind-trick - enhancing the inflation target. The trouble is there is no fast mover yet. And it is hard to be experimental with this unless one is forced to. A bad move can displace the inflation credibility that most central banks fought hard to achieve.
I think how the central bankers will react will depend on the nature of problem they are reacting to. A minor risk-off or continued commodities sell-offs will most probably elicit a (now) conventional reaction of QE or increasing NIM. But a only a real full blown crisis will bring in the inflation retargeting (along with host of other measures presumably).
And given the specifics of the various institutions and home politics, I would bet in such a full blown crisis - the governor of the Bank of England is the most likely candidate to take the first step. And ECB will likely be the last.
Wave the hand and say inflation should be 4%, and leave the rest to the Midi-chlorians.
So if you are an investors from EU area looking for a tail risk protection, a relatively cheap hedge is paying 5s30s in GBP vs. the Euro are. And most likely this will be Brexit proof. If indeed we have such an outcome, probably a selling of the long end of curve by non-UK investors will lead to a steepening of the GBP curve.
The spread has tightened recently but still near recent lows.

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