LONDON (Reuters) - The ECB on Thursday took its biggest step yet to withdrawing crisis-era support by saying it plans to end QE in December, a day after the U.S. Federal Reserve again raised rates and signaled an even faster pace of hikes than previously expected.
But while the world’s two most powerful central banks both appear to be on the path towards policy normalization, the contrast couldn’t be starker: The ECB is taking baby steps, while the Fed is powering into the distance with increasingly large strides.
That’s not a criticism of Mario Draghi and the European Central Bank. Their caution is probably justified, as is the Federal Reserve’s confidence under new chairman Jerome Powell.
Draghi appears to have pulled off the feat of appeasing those ECB policymakers demanding more clarity on the QE exit and normalization while keeping policy extremely accommodative and leaving the door open to loosening it further if need be.
The euro spiked higher but then slumped as much as two cents to $1.1650, on track for its steepest one-day fall since October last year. Euro zone bond yields also fell. Good news for euro zone stocks, not so much for emerging markets.
(For a graphic showing Euro reaction to Draghi, click here: reut.rs/2JOfnYh)
For financial markets, the ECB’s prudence is welcome, as a double dose of U.S. and euro zone tightening is not without risk - especially with global trade war tensions on the rise.
On the face of it, raising interest rates and withdrawing crisis-era stimulus is a clear sign that economies, markets and the financial system at large can take it.
The U.S. economy is enjoying its second-longest expansion since World War Two, the labour market has rarely been tighter, corporate profits have never been higher and Wall Street is in rude health.
The euro zone economy has emerged from the crises of 2008 and 2011-12 to grow at its fastest pace in seven years, unemployment is at its lowest in a decade, and company profit growth in the first quarter of this year nudged 30 percent.
If you can’t tighten now, or at least signal tightening, in the case of the ECB, when can you?
Yet these rosy stats and favourable historical comparisons are precisely why tighter monetary policy than is currently priced may unnerve investors: this is probably as good as it gets.
On cue, JP Morgan on Thursday outlined how to best prepare for the turning cycle in a note entitled: “The best late-cycle trades - Rotations for an outcome that’s highly anticipated but hardly positioned for across markets”.
“The sense of anxiety is more palpable in client discussions and in the news flow than it is in investor positioning,” the note said. “Although almost every client meeting includes questions about where the economy and markets sit in the cycle and news trends around defensive themes are surging, cyclical positions still dominate investor portfolios.”
It’s becoming increasingly clear that the euro zone has run into a soft patch. Economic data is consistently coming in below forecasts, which has cast doubt over the strength of the expansion. Draghi himself said the soft patch probably extended to the second quarter in some countries.
Citi’s euro zone economic surprises index has fallen off a cliff, and is now the lowest since 2011. The gap between the euro zone and U.S. surprises index is the widest in almost a decade.
(For a graphic showing Euro zone economic surprises index, click here: reut.rs/2JIIDiJ)
That can be attributed to euro zone expectations simply being too lofty due to the outperformance of the last couple of years. But the outlook is darkening, and earlier this week Germany’s DIW economic institute slashed its 2018 growth forecast for Germany by 0.5 percentage points to 1.9 percent, and by 0.2 percentage points to 1.7 percent in 2019.
The ECB upgraded its inflation outlook to 1.7 percent for this year and the next two. But that is probably still short of where policymakers would like it to be, hence why Draghi said “significant” policy accommodation is still required.
The region’s banks aren’t doing all that brilliantly either. Euro zone financials are down 13 percent this year, underperforming the wider stock market which is broadly flat.
Euro zone banks have to hold large amounts of sovereign bonds to beef up their capital and liquidity buffers. If ECB ending QE pushes bond prices lower, banks’ capital positions may be weakened. Recent ructions in the Italian bond market won’t have soothed any nerves either.
Higher rates and tighter policy need not be bad news for banks if the yield curve steepens. But curves are flattening, particularly in the United States, where the benchmark 2s/10s curve is the flattest since September 2007 and less than 40 basis points from inverting.
There is intense debate about whether it is different this time, but the fact remains that an inverted yield curve has preceded all five U.S. recessions over the past 40 years.
As Harm Bandholz, chief U.S. economist at Unicredit, notes, once the impact of the fiscal stimulus fades, growth will start to slow. That’s why he expects only one rate hike next year, which will be the Fed’s last.
It may also be why money markets still only attach a 50-50 probability to a fourth hike this year, even though the Fed said on Thursday that is what it will deliver.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever; Editing by Hugh Lawson