- Draghi gets even more dovish
- China cuts rates for the first time in two years
- Central bankers are desperate to generate some inflation...but are at risk of failing.
It seems that Mario Draghi is currently being granted a weekly platform from which to dangle the carrot of US style QE and to try and jawbone the Euro currency lower. He certainly did not disappoint this week, as indicated in these Bloomberg headlines from early Friday;
- DRAGHI: WOULD BROADEN PURCHASES IF INFLATION RISKS MATERIALISE
- DRAGHI: WOULD BROADEN PURCHASES IF POLICY NOT EFFECTIVE
- DRAGHI: QE IN US [AND] JAPAN HAS LED TO SIGNIFICANT FX DEPRECIATION.
Some would make the point that deflation risks are already material and it could therefore be argued that policies have not been effective. Those views will certainly not stop Draghi trying to weaken the Euro through extraordinary policies and jawboning, and many believe it is only the orthodox German camp that is preventing QE from being implemented immediately.
Whether QE helps the European economy is not really the point. Everyone expects QE to be implemented and Draghi simply will not disappoint. It is likely that a further 10% to 20% depreciation in the Euro will make more of a difference to the real economy than QE and that is why Draghi is so keen to help the market buy into his narrative for a weaker Euro. The chart below shows the Euro vs the US Dollar since early this year. We have highlighted the recent pattern of modest bounces within a larger downtrend. Draghi’s comments have helped the Euro trade down to recent lows. Although the short Euro trade is quite crowded, the trend is well established and has the support of the ECB. We have re-established our bearish Euro positions against both the US Dollar and Sterling.
In the other major announcement on Friday, the Peoples Bank of China (PBoC) reduced both its 1 year deposit and lending rates for the first time in over two years. Financial markets decided that this was universally bullish of risk assets which seems to be a reasonable response. With the Chinese economy slowing, demands for stimulus have been growing, and when this news comes on the same day that Draghi is dangling the QE carrot, this has to be bullish for risk assets, right?
Looking at the move another way, the rate cuts from the PBoC look like a defensive ploy from a weak position. The benignly bullish China spectators believe that the authorities can control their economy and that all stimulus is good news. From where we sit, the news for China has been unrelentingly bad of late. House prices continue to crumble, PMI surveys and hard economic data have been weaker than expected and the currency has been incredibly strong against both its major and regional trading partners. Furthermore, bad debt levels at banks (and if allowed, in the shadow bank sector as well) are rising.
China has always grown by either expanding fixed asset investment or net trade. With the unsustainable rise in debt leading to out of control corruption and now the rise in bad debts, the leadership have decided they cannot stimulate via fixed asset investment growth plus, with the world slowing down and the Yuan being so strong, they also realise that it will be very difficult to increase net trade. It is very possible that if the growth slowdown continues, Beijing will be comfortable with a weaker Yuan, especially if the Yen and Euro continue to weaken.
Taking a little step back here, it strikes us that central banks are becoming more desperate in their attempts to generate nominal growth and the extent that they are focusing more on trying to generate inflation, which really is just a tax on the majority. This desperation is clearly being led by the Bank of Japan followed closely by the ECB. This subject probably deserves a whole commentary on its own, so we will keep this section brief. The chart below shows market based measures for both Europe and the US.
As can be seen, the bounce that coincided with the recent rally in global equities has petered out. Rising risk appetites as measured by equity markets, coupled with further central bank stimulus, has so far not worked. The fact that US bond prices rose on Friday (yields fell) when risk assets were so strong after the Draghi speech and PBoC rate cuts indicates to us that the global disinflationary forces remain very powerful. If inflation indicators continue falling despite all the current central bank stimulus programmes, we will have to entertain the view that central bank reflationary policies are failing.
So it’s been an interesting week. Mario Draghi is desperately seeking a weaker Euro and is employing negative interest rates, verbal intervention and shortly QE to do so. We think he will get his way and expect the US Dollar and Sterling to strengthen against the Euro over time. China is seeking new ways to offset their growth slowdown. We expect they will have to up the ante quite soon and wonder whether they will move to weaken they Yuan. Frankly, this all fits within our strong US Dollar theme we have outlined in recent weeks/months. A strong Dollar with weak Euro and Yen will intensify the deflationary pulses that are coursing through the global system and the lack of bounce in market based inflation expectations seems to be backing this view. If markets begin to believe that central banks are failing in their reflationary policies, then things really will get interesting.