Pain Trades: A Discussion of Two Troikas

In an unusual occurrence, both the Federal Reserve and the European Central Bank will hold policy making meetings next week.  Most recently a consensus has emerged in favor of an ECB refi rate cut next week. In the US, spurred by a reading of the FOMC minutes, many observers have been talking about the tapering off of the Fed's long-term asset purchases in light of what appears to be above trend growth in Q1 (which will be reported tomorrow).    On both issues it makes sense to consider what can go wrong with the consensus view.  

To be sure, we have been anticipating a rate cut by the ECB in Q2 and recognize that the top ECB officials, including Draghi, have opened the door to lower refi rate, if the economic data worsened.  It has worsened, as the flash PMIs earlier this week showed.   

Yet there are reasons why an ECB rate cut is not a done deal.  First, the refi rate is not the key rate in the current environment.  It is the deposit rate, which is at zero and no one is seriously talking about cutting it.  The overnight rate is trading well through the 75 bp refi rate and EONIA is near 8 bp.  Given the tightening credit standards and the broken transmission mechanism for small and medium size businesses, it is not clear that a 25 bp refi rate cut would anything but symbolic.   Some adjustment of collateral rules, perhaps reduced haircuts, would seem to have greater impact than a refi rate cut. 

Second, given the push back against austerity, the ECB may not want to send a signal that could be interpreted as endorsing the relaxation of fiscal discipline.  ECB Vice President Constancio pushed back against views espoused by some, including EC President Barroso that "austerity had reached its limits" of public support, according to press accounts.  

Rehn, the EC's financial commissioner, confirmed that the EU has actually loosened the fiscal pressure and that the overall pace of budget cuts has slowed over the past year and the EU is easing the terms of some national bailouts.  Portugal, for example, reported that its Q1 deficit was 1.3 bln euros this year compared with 434 mln euros in Q1 12.  Spending rose 7.1%. 

The IMF appears be closer to the EU's point of view.  It has admitted that its had systematically under-estimated the fiscal multiplier and has recently shifted its focus a bit away from its more traditional austerity drive.  

The once united Troika appears to be fracturing, leaving the ECB as the last defender of the austerity agenda. Not cutting the refi rate would likely disappoint the short-market, which may not be totally undesirable from the ECB's point of view, and would send a message to the various countries that while the ECB can make liquidity available, it is up to the national governments to remove the structural barriers to growth

When it comes to monitoring the Federal Reserve, we have long maintained that the Troika there of Bernanke, Yellen and Dudley is the key.  Many observers, instead, have given greater credence to the more hawkish members, many of whom do not vote on the FOMC, who discuss the desirability of tapering off the asset purchases and moving toward the exit of QE.  

The US appears to be experiencing its now typical spring swoon.  The economy lost momentum last Q1 and this is spilling over into Q2.  At the same time, price pressures have eased.  Consumer prices in March were 1.5% above year ago levels,  The core PCE deflator likely remained near 1% in Q1 13, half of the FOMC's target.  Even if one doubts these official measures, the 100-day moving average of gold fell 3% in Q1 13 after a decline of a similar magnitude in Q4 12.    This is also not consistent with inflation worries.

The combination of weaker growth and soft price pressures is suggest that discussions of tapering off purchases is not only premature, but pointing in the wrong direction. Instead, the doves may make a more compelling case to accelerate the purchases.  The hawks are likely to be more circumspect and this may give the doves a clearer field. 

To be sure, if the Fed were to decide to increase its asset purchases, we do not think it is particularly likely next week.  However, if it looks as if Q2 growth is slowing sharply and core price pressures continue to ease, accelerating long-term asset purchases seem more likely than tapering off in Q3.