Much attention was paid to the ECB meeting last week, not least following Italy’s bungled referendum and change of government. In the end, however, none of these events changed the basic consensus among investors that the EUR must fall and the Dollar must rise. The ECB issued three messages to the market: First, the overall volume of bond purchases will be increased via an extension of the length of the ECB’s QE program. Second, the marginal pace of purchases will be reduced by EUR 20bn per month to EUR 60bn per month starting in March 2017. Thirdly, ECB President Draghi was unambiguously dovish in his press conference as he admitted that the volume of bond purchases is not consistent with the ECB’s own objective of reaching its 2% inflation target. The first two points can obviously be interpreted as either bullish or bearish for EUR depending on whether you think the overall stock or the marginal rate of purchases is more important. Faced with this rather complex and ambiguous conundrum the market chose instead to take its guidance from Draghi’s dovish comments, so EUR ended up trading lower. In a market obsessed with extending any prevailing momentum this conclusion should perhaps not have surprised very much. Beneath the bonnet, however, the ECB is obviously trying to balance conflicting interests among its members as the limits to bond purchases imposed by current rules are drawing closer.
In addition to the impact on the EUR, the ECB also removed the rate floor on bond purchases and opened up for purchases of bonds between 1 and 2 years tenor. This resulted in steeper yield curves in the Eurozone. Arguably, the tendency towards steeper curves is more important that the currency impact, because the really big unresolved question facing the ECB – and Europe – is how to prevent another blow-up in European periphery bond markets if US inflation continues to rise and pushes term yields higher. The US should be able to stomach modestly higher nominal bond yields as long as inflation is also going up, since this would keep real yields contained. However, the Eurozone will struggle to generate inflation due to its failure to recapitalize its banks, so rising real bond yields here could ultimately put bond markets in Europe’s over-indebted and unproductive periphery economies under renewed pressure (quite aside from pushing the EUR higher versus the Dollar since currencies move with real rates).
This week the focus will shift to the Fed, whose second rate hike is already fully priced in, wherefore the forward guidance is more important than the hike itself. Core CPI inflation is already above the Fed’s 2% target, oil prices are surging and unit labour costs are rising. Never before has the Fed allowed the US economy to approach full employment with only one hike on its books and the Fed would currently have to hike more than eight times just to get the policy rate to neutral. Inflation risks are also rising due to Trump’s promise to pursue Reagan-type policies of fiscal stimulus and deregulation. Ordinarily the Fed would simply hike rates by whatever amount required in order to crush inflation, but in today’s economy the Fed could trigger important economic headwinds if it gets too hawkish. For example, the US carries twice as much debt today as it did when Reagan took office and while interest rates declined sharply during Reagan’s eight years in office, which freed up room to spend more as debt service costs declined this is not the case today. Under Trump rates will likely go up and debt service costs increase. Debt service costs for the US economy are currently just shy of 7% of GDP, but they will rise by 3.3% of GDP for every 100bps rise in yields due to the enormous US debt stock. Mortgage applications have already started to fall sharply in response to what has so far been modest bear market steepening, in fact pro-rata with the fall in mortgage applications in 2013, which ultimately prompted a U-turn on the policy of Tapering by the Fed. In addition to the large debt stocks, the Dollar could pose a threat to the US economic expansion, since the Greenback is already so strong that net exports are struggling (real exports declined 2.9% in October). Finally, years of not investing has pushed productivity growth rates to historical lows, which means there is not much downside tolerance for growth before the economy enters a recession.
It has not escaped anyone’s attention that oil prices are going up. Since most EM countries are net importers of oil, will this not hurt their economies? The answer is “Yes, but…” Asian and Eastern European economies are net oil importers (with important exceptions in Russia and Malaysia), so they will be impacted adversely by rising prices. However, they are only likely to get hurt a lot if oil prices go up a lot. The marginal cost is small at current low prices. On the other hand, the marginal benefit of the recent increases in oil prices to struggling oil exporters is enormous, even at current low prices. We therefore think the increase in oil prices around current levels is positive for EM as a whole, since the marginal benefit to the oil exporters is significantly larger than the marginal cost to importers.
Jan Dehn is the head of research at Ashmore Group Plc, a specialist emerging markets asset manager with over US$ 50 billion under management.