A Few Thoughts Ahead of the Weekend

The market reaction to Draghi's indication, once again, that interest rate policy has run its course, will be debated for some time.    Draghi delivered the goods that many investors said was lacking last December.  The ECB policy more than anyone expected.  

All the boxes were checked.  Although the end date was not extended beyond March 2017, the four-year TLTROS will run into the new decade, and Draghi indicated that rates will remain low well beyond the end of the asset purchases.  Moreover, the deadline was always soft.  

Many participants seem to have confused interest rate policy with monetary policy.  The ECB has taken significant unorthodox measures, expanding monetary policy well beyond the price of money itself.  Although we question the wisdom of removing interest rates from its toolkit, Draghi was directing investors attention going forward back to QE.  Some reports suggest that after easing the ECB "stepped back."  We do not think this is a fair representation of what Draghi said.  

In addition, there are three different issues that should not be conflated when thinking about the credibility of monetary policy: desirability, necessity, and effectiveness of the measures.  The new staff forecasts and the renewed deflationary pressures required some monetary response.  The issues of effectiveness is important, but one cannot judge that based on a few hours of price action. That said, even in the US experience, there was some evidence of diminishing returns.  

It does not mean that central banks have lost their credibility or the monetary policy does not work.     Indeed, we compare it to taking aspirin to get rid of a headache.  You take two aspirins, but and hour later you still have a headache.  Does it mean that aspirin does not work?  Does it mean that the doctor has lost her credibility?  You decided to take two more aspirin, and an hour later our headache may have dulled, but it is still there.  You take two more aspirin and all of the sudden you are drowsy and fall asleep.  

Perhaps the effect of monetary policy has been blunted by other powerful forces, like the drop in oil prices.    The IEA said opined earlier today that oil prices may have bottomed.  High-cost producers are cutting output.  It now sees a 750k barrel a day reduction of supplies, which is 150k barrels more than anticipated a month ago.  

The US, Colombia, and Brazil are anticipated to drive the cut in output.  Among OPEC countries, Nigeria and Iraq have seen output ease.  The IEA suggests that demand will rise by 1.2 mln barrels a day this year.  This is seen absorbing the bulk of the 1.7 mln barrel a day excess supply so that by the end of the year the surplus output is around 200k barrels a day.  

Look at what has happened to German 10-year break-evens.  They bottomed on March 1 near 68 bp and finished last week near 85 bp.  Now they are at 92 bp, the highest since the end of January.  

Germany holds three state elections this weekend.  Merkel's CDU may be the big loser, with the AfD the big winner.   There is some talk that a extremely poor showing for the CDU, but this seems exaggerated.  Of the three states, the CDU is part of the government in only one (Saxony-Anhalt), so the impact in the upper chamber of parliament will not be impacted very much. 

Also, on the federal level, the Merkel is in a coalition with the SPD, and the grand coalition also protects Merkel.  PredictIt shows a 19% chance that Merkel does not complete the year in office. In comparison, the odds of Brexit are a little more than 25%.  That said, the weekend elections could impact the Chancellor's decision of next year's national election.  As we have suggested, medium term investors need to give serious thought to a post-Merkel Germany (and post-Draghi ECB). 

China is expected to release industrial production and retail sales data over the weekend.  Industrial output is expected to have slowed.  Part of this may be the Lunar New Year, but the underlying trend is weaker in any event.  Retail sales, on the other hand, are expected to remain firm near 11% year-over-year.  This is important as it shows Chinese consumption is not adversely impacted by the decline in the equity market.  A small fraction of Chinese households own stocks and equities make up a small fraction of household net worth.  This is to say that the wealth effect is less than say the United States.  

Earlier today, China reported both yuan loans and total aggregate financing slowed more than expected in February.  This too could be distorted by the Lunar New Year.  If one takes the January upside blowout and averages with the February undershoot, the average is still more than CNY2 trillion and well above the longer-term averages.  

Beyond the weekend, note that next week, there are several major central bank meetings:  Fed, BOJ, BOE, the SNB and Norway's central bank.  Norway is the most likely to ease policy while the BOE is the most likely to stand pat.  Of course, the Fed and BOJ are not expected to change policy, but the odds are above zero.  Without dramatic euro weakness in response to the ECB meeting, the SNB may not feel a strong sense of urgency.  Against the euro, the Swiss franc is below its 100-day moving average.  

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