Macro Weekly – Here comes more QE from the ECB

by: Han de Jong

Macro-Weekly_Here-comes-more-QE_4-September-2015.pdf (54 KB)

Financial markets remain volatile as worries over developments in emerging economies and the global economy continue to affect confidence. While we think that some of these concerns are exaggerated, market turmoil could lead to a self-fulfilling prophecy. Risks to the downside are rising. Policymakers are likely to react to that threat. We have therefore changed our view on the likely policy actions by the ECB and the Fed. We believe the ECB is set to step up the size of its QE programme and we think the Fed will delay its first rate hike and not raise rates in September.

Manufacturing under pressure

Recent economic data has not been strong enough to reduce fear over the global cyclical outlook. Perhaps even the contrary. Business confidence indicators in many countries deteriorated in August. This is especially true for many emerging economies. And in many of these economies the Purchasing Managers Index in the manufacturing sector is below 50, indicating the sector is weak. The momentum of manufacturing activity in the US also seems to be softening, though US output appears to be still expanding. Europe has so far managed to buck the trend and cyclical indicators continue to look good and indicate continued above-trend economic growth. How long Europe can diverge remains to be seen.

China the culprit, EM vulnerabilities exposed

The most likely culprit is China. As the Chinese economy slows, many countries exporting to China are hit. That applies to many other emerging economies, less so to Europe and the US. Not too long ago, many people were arguing that risks in emerging economies were actually lower than  in many advanced economies as government indebtedness is generally significantly lower. This is turning out to be a very wrong assessment. Emerging economies are now suffering from a range of negative trends.  Lower exports to China is one. Falling commodity prices is a second, though this is partly related to China. Third, and this applies to Asian EMs, is the depreciation of the yen that has taken place during the last two and a half years or so, hurting competitiveness of other Asian EMs. Fourth is economic imbalances such as external deficits. A lot of money that has flown into EMs in recent years is now leaving, putting pressure on currencies of countries with external deficits in particular and on their domestic liquidity situation. Last, but not least, is poor macroeconomic management and political instability.

We remain optimistic, but confidence is tested

Our view has consistently been that the slowdown in Chinese growth is inevitable, but manageable. However, that does not lead to a hugely optimistic view on EMs, but we do not favour a China hard-landing scenario. We have also consistently believed that the outlook in the US and in Europe is strong enough to withstand any slowdown elsewhere. This view is increasingly tested, but we are not ready to throw in the towel.

Policymakers in China have the means and the ability to prevent a hard landing in our view. In addition, it seems as though the manufacturing cycle is overshooting to the down side. Output is developing weaker than demand. Such a divergence is temporary by definition and we think that demand will ultimately lead output. While falling commodity prices are bad news for commodity producers, they are actually beneficial to Europe.

ECB and Fed will react

The ECB and the Fed (and other central bankers, of course) have to formulate their policies against this background of uncertainty, volatility and downside risks. At his most recent press conference, ECB President Mario Draghi opened the door for more action. He indicated that the ECB’s current programme of asset purchases may last longer than until September next year as initially planned. Draghi had never excluded that possibility, but he now made the possibility of an extension very explicit. He also announced that the ECB is willing to buy a larger portion of specific bond issues (to be judged on a case-by-case basis), which opens the door to an increases of the size of their monthly purchases. Draghi also announced downward revisions to the ECB’s inflation and growth forecasts for the eurozone economy for the period ending in 2017.

Given the increased risks to the downside in terms of growth, given the fact that the new inflation forecasts show that the ECB is getting further away from reaching its inflation target and given that the ECB is actually quite happy about what it has achieved with its QE programme, we think it is likely that the ECB will step up its purchases in the months ahead. They will want to defend, consolidate and build on their success so far.

20 bn euro extra per month to be announced in October

The most likely scenario in our view is that the ECB announces an increase in the size of its asset purchases each month by some 20 bn EUR and that this will be announced following the next ECB Governing Council meeting in October. We believe that will push borrowing costs lower and also the euro. Indeed, we have revised our bond yield forecasts lower as well. The result of this easing will be that the economic recovery will remain on track, which is why we are not lowering our growth forecasts for the eurozone at this stage.

Fed delays

Until now, we had assumed the Fed was going to implement its first rate hike in September. But given turmoil in financial markets and the downside risks to the growth outlook this implies, we think it will more postpone the rate hike. Assuming calm will return to financial markets during the weeks or months ahead, we believe that December is now a more realistic moment for the first Fed rate hike.

Healthy labour market

Positive US labour market data for the month of August, released on Friday, do not change our view that the Fed will delay until December. Employment growth was below the recent trend at 175K last month, but that still represents a decent pace. In addition, job growth in the previous two months was revised up by 44K. Meanwhile, the unemployment rate fell significantly, from 5.3% to 5.1%, and wage growth firmed.

Draghi’s view on China and other EMs.

In his press conference, Mario Draghi said a couple of things I thought deserve to be highlighted explicitly. I was most surprised by something the ECB President said about China. He was asked by a journalist if he had received any information from the Chinese authorities about what was going on in their economy. He answered he hadn’t but that he hoped and expected  he would get some at the G20 meeting in Ankara on 4 September and Friday 5 September.  The way he said it sounded as though at present he really does not have a particularly good idea of what is going on in China…..

Also interesting I thought, was Draghi’s repeated remark that the challenges confronting emerging economies these days are not going to disappear any time soon. This adds to our conviction that the ECB will feel compelled to take additional policy measures.

tabel 4 September