ECB Drives Markets

 It is not about the data today though there has been a slew of data that in other times would have moved the market.  The flash HSBC China PMI was reported above expectations at 49.8 from 49.6 in December, but still shows manufacturing sector of the world's second largest economy is still slowing.  Eurozone's flash PMI was also a bit better than expected, consistent with 0.2%-0.3% quarterly GDP.  

The UK reported considerably better than expected retail sales, but sterling remains offered.  December retail sales were expected to have fallen 0.6.% instead they rose by 0.4%.  Excluding autos, retail sales rose 0.2%.  They were expected to have fallen by 0.7%.   

The ECB's announcement helped spur a new round of dollar-buying against most of the majors, save the yen.  After a quiet Asian session, Europe has extended the euro's drop to $1.1220, which corresponds to the 61.*% retracement of the entire rally from record lows to record highs.  We had thought that much of what the ECB would announce had already been largely discounted.  The evidence was the rally in European stocks and bonds, and the persistent decline in the euro.  There was not only no bout of profit-taking, but existing trends accelerated.   

The asset purchases are not really much larger than expected.  The 60 bln euro a month includes the covered bonds and asset-backed securities, which are already being purchased at a rate of about 10 bln euros a month. It appears 5 bln euros EU institutional bonds will be bought  a month.  This leaves about 45 bln a month of sovereign bonds.

There is some pooling of risk but only for the buying of European institutions' bonds, like the EU and EIB.  Total amount to be bought in the eighteen months from March through September 2016 will be roughly 10% of eurozone GDP.  This is in line with the first round of asset purchases by the Federal Reserve and Bank of England.  In the period of time it takes for the ECB to buy a tenth of its GDP, the BOJ will be buying a quarter of Japan's GDP (worth of assets). 

Perhaps one of the bigger surprises was the open-ended nature of the purchases.  Draghi was very clear on this point:  "They are intended to carried out until end-September 2016 and will in any case be conducted until we see a sustained adjustment in the path of inflation" (emphasis ours). Critics will focus on this or that technical hair-splitting detail.  They were forged not in the head of some academic, contemplating the theoretical best solution, but in the furnace of institutional and political reality.  

The more significant problem is one of efficacy Will it boost inflation?  Reports indicate that the ECB's model shows the asset purchases could boost CPI by 0.4% this year and 0.3% in 2016.  The experience of other central banks makes us more skeptical.  The Swiss National Bank expanded its balance sheet to 80% of GDP and still was experiencing deflation, even before it abandoned its currency cap.  The BOJ has been unable to engineer much inflation, and, in fact, revised down its forecast for core CPI  (adjusted for the sales tax increase).   

More promising for inflation may be the currency channel.  Consider that from March through early October last year the euro declined by 5.4% on a trade-weighted basis.  Since the middle of December, it has depreciated another 7.8%, thanks in part to the SNB's recent decision.  

The ECB's new purchase program will not start until March (by which time inflation will likely be even lower.    Investors’ attention is shifting from monetary policy to European politics.  Greece's national election is Sunday.  The party that has a plurality of votes will be given 50 extra seats in the 300-person parliament and have three days to put together a government.  Polls have consistently shown Syriza ahead, and if anything, that lead has grown.  Italy's presidential election starts next week as well. 

Samaras has made a couple of political gambles and lost.  He first gambled that parliament would eventually support his presidential candidate.  It did not.  He then gambled that demonizing Syriza would drive voters to him.  He ran a lackluster campaign.  He did not permit another candidate from his party, who has less political scar tissue and few enemies, to take the reins, even though that would have increased the likelihood of success.  Rather than campaign as a reformer as he did in 2012, Samaras ran defending a poor, even if somewhat improved, status quo.  

Just as Greece was the canary in the coal mine in 2010, so too now, it needs be recognized that it is not a one-off.  Pademos in Spain, which is ideologically kindred spirit with Syriza, is leading in polls there for the national election later this year.   Between the change in the way the EC will enforce fiscal discipline and the new monetary action by the ECB, policy is evolving away from the austerity demands seen earlier.  However, it may be too little too late.