ECB showing commitment, but who is afraid of tapering?

by: Han de Jong

The ECB chose to surprise markets with a rate cut, stressing its commitment not to take any risk with deflation. We had expected them to hold off for another month, but were happily surprised by the decision. Meanwhile, US data, while still difficult to read because of the government shutdown, was better than expected. A large majority of commentators are now arguing that ‘good news is bad news’. In that line of thinking, good news on the economy is bad news for financial markets as it makes early tapering more likely and we have seen over the summer what the effects will be. I think the ‘good news is bad news’ argument is absolute rubbish!

ECB cuts the refi rate and maintains an easing bias

The ECB surprised markets last week by lowering the refi rate from 50bp to 25bp, a new record low. The deposit rate stayed at 0.0%. ECB President Mario Draghi indicated in his press conference that the Bank could provide more monetary stimulus should that be considered necessary. Draghi essentially followed the logic we have highlighted in the past. With inflation clearly below the ECB’s target and heading lower, the economy struggling to grow and clearly operating below potential, it is easy to conclude that monetary conditions are too tight and need to be loosened. Many will object and argue that rates were already extremely low and that this rate cut does not mean much. When central banks move interest rates, it is typically in steps of 25 bp or 50 bp. One must look at the broader picture. Only a few weeks ago, the euro was trading at USD 1.38. It is now down to 1.33. Still too expensive in our view, but an improvement all the same, helped by the ECB’s rate cut. The ECB also needs to consider borrowing costs further out on the curve, and by lowering its refi rate and indicating that it might do more, it tries to anchor borrowing costs further out.

There has been some criticism of the ECB for its decision last week, but we believe they made the right one. And by not waiting for another month, they indicated a sense of urgency and achieved a little surprise factor, which will help their cause.

On the data front, the most important ones in the eurozone were the orders and industrial output data in Germany. Orders were very strong, driven particularly by foreign orders for capital goods. Output actually fell in September. At the risk of being labelled too optimistic, it seems to me that the orders data is the more relevant and correct series to look at this stage, as the improvement this data is showing is consistent with data released elsewhere. The decline in the output data does not fit in with most other evidence. For example, Chinese trade data for October was strong and Japanese data has recently also been encouraging.


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Don’t let them talk you into fearing tapering

US data was also positive last week. The employment report provided the biggest surprise as 204,000 jobs were created on a net basis in October according to the establishment survey. Economists, including ourselves, had expected a considerably lower number. There were two reasons to be cautious. First, the employment report had disappointed a little in recent months and, second, the government shutdown was likely to have a negative impact on the October number. Last Friday’s report included an upward revision of 60,000 for the last few months, so the recent past now looks stronger than it did before. And to what extent the shutdown has affected the data, we still do not know. The so-called household survey showed a drop of 735,000 jobs in October. So there is an unusually large gap between the two reports. It seems, however, that the latter report was significantly affected by government workers who were temporarily let go. While it is difficult to assess the distortion of data due to the shutdown at this stage, I think the conclusion is justified that the US economy is doing well and that the labour market continues to improve at a modest pace.

Third quarter US GDP data also surprised positively, showing annualised growth of 2.8% qoq, though it must be said that 0.8% of that was due to inventory building. The detail of the report was perhaps not quite as strong as the headline suggested, but it certainly was not below expectations, confirming the view that the US economy is doing nicely.

US mortgage delinquencies and foreclosures dropped sharply in Q3, indicating that the housing market, personal balance sheets and bank balance sheets are all healing. This is hugely encouraging for returning the economy back to normality.

US personal income increased by 0.5% mom in September after an equally large rise in August. The inflation component in this data eased. The PCE deflator only rose 0.1% mom and the yoy rate fell from 1.1% to 0.9%, though the Fed’s favourite inflation measure, the core PCE deflator, was unchanged at 1.2% yoy. On this basis, one would also consider inflation uncomfortably low to the Fed. Due to easing inflation pressure, the increase in real personal income was actually quite strong. Nevertheless, spending growth was weaker than income growth in September and the savings rate rose. The weaker spending growth will, most likely, be temporary as I think it is a response to tax hikes implemented earlier and to the rise in borrowing costs over the summer following the ‘tapering scare’.


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Overall, it looks to me that the global economy is doing fine and growth appears to be accelerating gradually, which is in line with our long-held view.

‘Good news is bad news’: absolute rubbish

Markets have recently regularly responded negatively to good economic data, unleashing a new religion: the ‘good news is bad news’ faith. In that line of thinking, good economic news triggers expectations of tightening of monetary policy, which is considered bad for markets for risky assets. The supporters of this view point at what happened after Fed chair Bernanke first mentioned tapering of asset purchases in early May. Yields on 10Y US government bonds rose by 140 bp over a four month period. This was actually similar to the bond market’s response to the unexpected rise in official rates in February 1994. That period has gone down in the history books as a savage bear market in bonds. The rise in yields earlier this year had a big impact on capital flows in the world. Emerging markets saw large outflows and the S&P500 lost 100 points (initially, and then recovered all of the lost ground, and more.) The good news is bad news school teaches that something similar will happen when the Fed actually tapers and strong data brings that moment closer.

I think the argument described makes no sense whatsoever. I have several reasons for this. First, tapering is not a matter of if, but of when. That makes the recovery of markets for risky assets after the Fed’s failure to taper in September all the more surprising. Why would holders of risky assets stay in them and, in fact, rebuild positions, knowing that the moment of truth is coming anyway, be it in December or a couple of months later? One would be pushing one’s luck if one tried to stay until the last day before a big correction starts. My colleague Nick Kounis has referred to the period following the first mention of tapering as a ‘dry run’. Markets responded strongly and nervously, but in the end nothing happened, the Fed did not taper. The dry run gave everybody time to reflect. Virtually all emerging market economists that I have read responded by arguing that the negative reaction of the market was overdone as most emerging economies are in a much better position now than they were before previous US tightening cycles. Market participants appear to have taken that view on board, and emerging equities have regained more ground than they had originally lost. So why would they panic again when the tapering actually starts? Pushing up emerging equity markets in the meantime seems a stupid thing to do unless one is convinced of the argument that emerging economies will be better able than before to cope with a change in the direction of US monetary policy.

A second argument for not fearing the tapering is what happened to borrowing costs during the various programmes of quantitative easing. Just before and at the very beginning of the first QE programme, US government bond yields fell sharply. That however, was largely an announcement effect. Bond yields subsequently rose during the programme. The knee-jerk announcement effect of lower yields was much smaller in the case of QE-2 and QE-3. In fact, bond yields were higher at the end of QE2 than at the beginning and the same seems likely in the case of QE3. The conclusion I draw is that the effect of QE on bond yields is less impressive than people think and the reversal of the QE programme may equally have little impact.

A third argument is that the Fed must have been unpleasantly surprised by the market’s response to Bernanke’s remarks in May. As it turned out to have been only a dry run, the Fed can study the consequences carefully. One of their findings surely will be that the economy cannot cope with a rise in borrowing costs as large as occurred over such a short period of time and therefore the process of tapering must be cautious and well managed.

Markets for risky assets have done well in recent months and it is only natural that they would take a breather. But the case for risky assets remains overwhelmingly strong and is not weakened by the prospect of tapering in my view. Accelerating growth will improve credit quality and provide another push to profit growth. And with central banks now perhaps a little more mindful of inflation undershooting their targets, it seems very unlikely that they will follow a particularly restrictive monetary policy. The combination of accelerating growth, easing inflation, at best modestly rising borrowing costs and return prospects for other assets looking unattractive, mean that the appeal of risky assets continues to be strong.