Summary:
- Core Eurozone CPI inflation rate falls to 0.70%, a multi-decade low
- This occurs at a time when the PIGS' average unemployment rate rests near 24%
- Deflation threat in Europe real as GDP in Europe likely to peak this year
- European hawks moving towards dovish side of the fence, opening door for more QE
- Implications: stronger European stock market, stronger USD, weaker commodity prices, stronger global growth
Back in February I laid the groundwork for why we should expect to see the European Central Bank (ECB) massively expand its balance sheet (see article). The case for expecting to see the ECB print is only increasing as core Eurozone inflation is currently matching nearly a 25-year low at a 0.70% year-over-year (YOY) rate.
Source: Bloomberg
This is occurring at a time when unemployment in the PIGS (Portugal, Italy, Greece, Spain) rests near 24% and Eurozone unemployment is still in double-digit territory.
Source: Bloomberg
As the two charts above highlight, there is plenty of cover for the ECB to expand their balance sheet as the Eurozone risks outright deflation amidst stubbornly high unemployment. While current inflation rates and unemployment data alone suggest this, fiscal and monetary authorities are likely to have another justification in the months ahead with a slowing economy as well.
Money supply growth rates tend to lead economic activity and this relationship is shown below with ECB M1 money supply growth relative to the Markit Eurozone Manufacturing PMI. The slide we’ve seen in M1 growth suggests the European economy should decelerate for much of 2014. The last time we saw a prolonged deceleration in the Eurozone was in 2011 and that was the last time the ECB ramped up its printing presses. Should the Eurozone PMI fall as M1 growth rates suggest, the ECB will likely resort to expansionary measures once again.
Source: Bloomberg
Ever since 2011, there has been a tighter relationship between M1 money supply growth and the ECB’s balance sheet, which you can see below (M1 growth rates are shown advanced and inverted relative to the ECB’s total assets). The slide in the M1 growth rate suggests the ECB should begin ramping up the printing presses now and continuing into at least early 2015.
Source: Bloomberg
The case for the ECB to print to stave off deflation in Europe and turn around their economy is so strong that even the staunchest hawks on the ECB are turning to doves as the following article illustrates (emphasis added).
ECB hardliner Weidmann comes in from the cold as deflation threatens
As recently as last November, Jens Weidmann steadfastly opposed any move by the European Central Bank to print money to buy assets and buoy the euro zone economy. No longer.
The Bundesbank chief, known for his hardline stances at the ECB and as head of the German central bank, is now ready to support such quantitative easing (QE) if he and his ECB colleagues deem it necessary.
What has changed is that "the situation has changed", according to one person familiar with the German's thinking, speaking on condition of anonymity.
Euro zone inflation has slowed to 0.5 percent from 0.9 percent in November, falling far below the ECB's target of just under 2 percent and stoking fears the bloc could become stuck in a prolonged period of so-called "low-flation", or even sink into outright deflation.
Such a scenario risks undermining the efforts of crisis-hit countries on the euro zone periphery to shape up their economies, and could ultimately hit growth across the board if households defer purchases in anticipation of lower prices in the future.
Seeking to head off such a drop in inflation expectations, the ECB's governing council said earlier this month it was unanimous in its commitment to use unconventional tools — central bank-speak for things like QE - to counter a protracted period of low inflation.
The unanimity meant Weidmann was on board. This matters because as leader of the hawkish faction on the 24-member council, he can shape debates and restrict policy moves. Last May, for example, he prevailed in limiting the size of an interest rate cut…
With the straightforward QE debate, Weidmann has softened his tone. Late last month, he said such a program was not out of the question…
By acting preemptively, even just by talking about QE at this stage, "the action itself doesn't need to be as large", said Berenberg bank's Christian Schulz, a former ECB economist.
It appears that the ECB is already testing the water and prepping markets for an eventual QE program this year. Benoit Coeure, a Mario Draghi confident, spoke at an IMF conference in Washington, D.C. that a well-structured large-scale asset purchase program would fit with the ECB’s price stability mandate. Excerpts from his speech are given below (emphasis added).
Asset purchases as an instrument of monetary policy (04/13/2014)
Thank you very much for inviting me to open this session on whether central banks should continue to target longer-term bond yields in normal times. My first instinct when presented with this question was to provide a rhetorical answer and say that to continue targeting long-term bond yields one has first to have started doing it. And indeed, the ECB has so far only intervened in long-term bond markets, such as the covered bond market, to restore monetary policy transmission in malfunctioning market segments and help enforcing a given monetary policy stance. We have not so far resorted to a policy of targeted asset purchases that aim to alter the monetary policy stance — what is universally, if in my view inaccurately, referred to as quantitative easing.
On second thoughts, however, this would be the wrong way to reply. It would not only be wrong because we have recently made clear that asset purchases are an instrument that we are ready to use if we deem necessary…
Overall, the yardstick for the success of any targeted asset purchases would not be the size of our balance sheet, but the observable effect of our operations on term premia across markets and jurisdictions. Or put differently, asset purchases in the euro area would not be about quantity, but about price. This is why I said that quantitative easing is a misnomer.
Not to put the cart before the horse, but before we can talk about the ramifications of the ECB ramping up the printing presses we need to first discuss the backdrop that occurred BEFORE the ECB printed. First we saw the Eurozone economy slow and with it fears of the European Union breaking up and possible government defaults. Bond yields on peripheral European country debt spiked and globally stocks sold off. The S&P 500 fell just over 20% and the Euro Stoxx 50 Index fell nearly 40%. Given the ECB is already front and center with their communication and intentions of stepping in should risks escalate, we are likely to see a milder decline than was seen in 2011. That said, stock market weakness caused by slowing in the Eurozone does remain and should be monitored in the weeks and months ahead.
Economic data surprises collapsed in 2011 as the Eurozone economy slowed as seen by Citigroup’s Economic Surprise Index for the Eurozone. Currently the surprise index is close to neutral and we haven’t seen the data strongly disappoint, but as it does stocks will likely weaken.
Source: Bloomberg
When the economic data weakens enough to cause the ECB to print the ramifications of the ECB significantly expanding its balance sheet are pretty clear, with an obvious one being weakness in the Euro relative to the USD, stronger stock markets, and weaker commodity pries.
Source: Bloomberg
Source: Bloomberg
Summary
The case for the ECB to print later this year is growing by the day with opposition such as Bundesbank chief Jens Weidmann falling by the wayside. While the ECB ramping up the printing presses would be bullish for risk assets, we have to remember that we saw widespread market weakness before the ECB stepped in and the lack of market weakness may be the only thing holding back the ECB at this point. For that reason we can’t rule out a market decline over the coming weeks to months before the ECB eventually prints.
