What happened: ECB Meeting/press conference happened on Thursday this week, which sets out the monetary policy of the eurozone for March.
Why does it matter: ECB is embarking on a journey to hopefully normalise its interest rates (meaning increasing interest rates in the long run) and taper/unwind its more than €1.8 trillion excess liquidity (excess CASH in the eurozone). When the market views next central bank step as towards normalising its monetary policy, this usually means “higher” mortgage/loan/bond rates for you than present…BUT… more importantly, when the biggest buyer (Central Banks) in the town stops buying more stuff, the music stops…. what happens then is usually ugly…
What did the markets do? Relatively dovish ECB meeting combined with the Italian Election result is likely to keep the EUR from strengthening further vs USD (currently 1.2307 EURUSD) and if anything, the technicals suggest 1.20 EURUSD as a short-term target range. Forward short end (0-2yr) interest rates are relatively unchanged as well, with the long end of the curve flattening (10yr and 30yr bonds rallying faster than 2yr bonds), that in itself means the market does not believe the ECB can hike much more before hitting a ceiling (also referred to as the terminal rate in fixed income markets).
Overview: ECB Draghi leaned towards “dovish” side, meaning the governing council (who makes the decisions by vote of majority) were not convinced that there was sufficient inflation pressure to change the forward guidance (the ECB expectations of what future could entail) of its monetary policy actions significantly (monetary policy is what Central Banks can do i.e. cut rates/print money etc.). There was only one minor change in the ECB language which was that the “increase of QE in terms of size and/or duration” was removed. Additionally, the ECB acknowledged risk to normalisation are mainly external factors including increased protectionism (finger pointed at the US tariff) and FX risk (strength of euro). Unsurprisingly, Mr. Draghi decided to swerve the subject of the Italian Election result that was dominated by anti-EU sentiment…although he did acknowledge it could reduce the confidence of the eurozone reform.
For more details see: https://www.ecb.europa.eu/press/pressconf/2018/html/ecb.is180308.en.html
What this means: The ECB is committed to start tapering its €30bn monthly QE further by the end of Sept 2018 or beyond if necessary. Market for now expects QE to end by either “end of Sept 2018” or “end of Dec 2018. This means that the “excess cash” the ECB has built up will finally start to reduce rather than increase, but it will take long time (if ever…) to normalise the excess cash to 0%. In terms of path of rate hikes, the first 0.20% rate hike is priced for June 2019 and another 0.20% by Dec 2019, resulting escape from the current negative rates. Currently unsecured euro interbank overnight lending (EONIA) rate is -36bps (this is the rate that the ECB cares about), which is equivalent of what US considers as the "Fed" rate or the rate the US Central Bank targets.
However, personally I feel this is rather bullish market expectations.
A) It assumes that the inflation pressure will pick up sufficiently, which has never touched close to 2% target even in the current ECB forecasts.
B) It assumes post Italian election mess will be resolved soon and reforms carried out.
C) Global protectionism and US boom-bust scenario does not materialise soon.
Also, even if the ECB does achieve 0% flat policy rate by end of 2019, progress from that point could be slower rate hikes to no hikes at all. Why? because a downturn in economy may happen globally due to higher interest rates leading to higher cost of debt and lower consumption. One must beware of the current global economy concerns and we cannot discount these big picture issues such as credit growth vs asset price (more on that another time).
How does this impact you? There is not awful lot of tinkering one can do on their personal finance or business in terms of interest rates cost. Going for fixed rates (without much hike priced in) is not a bad idea in case further problems down the line. Remember just because the central bank has not moved its official interest rate, does not mean the banks will keep their mortgage rates or company loans unchanged. Health of the banking system in Europe varies drastically according to different countries credit risk (i.e. how likely you will repay your debt) across public/private sector and amount of bad debt that floats around in that country. Therefore any rate differential should be adjusted by which Eurozone country you are in. As a rule of thumb, core euro countries have the lowest funding rate (i.e Germany) and peripherals with highest interest rates (i.e. Italy/Greece etc.).
There is a sense that like in US, a hiking cycle is done with urgency so that when the next recession hits, there is room to manoeuvre. At the moment, the ECB would simply be stuck with more QE option, which isn’t particularly attractive scenario if faced with another crises fight. This is one of the “hawks” (hawks meaning those who support higher rates/less Central Bank support) argument that the ECB needs to normalise as soon as possible when there is recovery and growth, rather than focus solely on the low inflation numbers.
Nevertheless, this is a difficult balancing act. With global QE taken out for most parts by end of this year (assuming BoJ still keeps its gas pedals going), the real term premium (i.e. the interest one would charge extra for lending out money for 5 years vs 1 day) should increase globally over time and stock market could have a sharp correction as cash goes from “trash” to “king”. For the market to think everything will be ok without central bank support is naïve and this is why a healthy amount of scepticism is required. Past 10 years of central bank intervention has been nothing short of extraordinary, all in the name of generating so called "growth".... Frankly many market participants haven't even experienced what a true free market was pre-2008 and we probably won't experience that for long time. Alternatively if recession hits too soon, we could all become like Japan where BoJ owns just about everything for decades….
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