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The US economic growth engine that might impact the ECB

Publication Date: 05 Oct 2018 - By Marcus Dewsnap By Marcus Dewsnap
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FX & Rates Macro Environmental, Social & Governance Multi Asset FX EU ex-UK USA UK

So, what is good for the US isn't necessarily good for the rest of the world! In the land of the perverse, how can it be that the generally acknowledged economic growth engine of the world firing on all cylinders has a negative impact outside the US? Think financial conditions.

The US bond sell-off that is gripping the rest of world results in higher yields. A bond yield can be thought of as containing two elements, real and inflation compensated. The more of rising yield that is attributed to the real element, then the tighter financial conditions will become, which is what is occurring.

It can be argued that the seemingly on fire US economy where overheating might become an issue needs tighter financial conditions. The trouble is that it doesn’t follow that the rest of the world necessarily needs, or wants, more expensive borrowing costs which constrain global growth expectations. Outside of the US, higher yields increase borrowing costs without the commensurate growth impulse that is occurring Stateside. 

Hence, it shouldn't come as much of a surprise to see equities under pressure, Emerging Markets in particular, when we add in a rising oil price concurrent with a strengthening dollar - a double whammy for crude importers. Dollar denominated debt becomes more expensive (and there is a lot of this out there) and as terms-of-trade move against these nations exports become more expensive. Those with large current account deficits become especially vulnerable.

The Eurozone, at least, has a large current account surplus. Still, higher oil prices and higher/steeper yield curves caused by an increasing real element are the last thing the European Central Bank (ECB) wants when economic growth is slowing. Policy is still extremely accommodative and will stay so even once new debt purchases via quatitative easing (QE) stop, as is expected at year-end. If economic growth is thought to be slowing to below trend, there is a good chance QE will continue as this could become disinflationary.

Thus far there has been little on reinvestment timescale aside from 'as long as is necessary'. So probably to continue until well after the first hike. At the September ECB meeting, President Draghi did say there will need to be a discussion at either the October or December meeting.  EUR20bn per month of reinvestment deserves attention. Especially if unwanted and in the Eurozone possibly unwarranted tighter financial conditions emerge. 

One option is to change the maturity profile via an Operation Twist, as periodically gets a mention. This will offer not only a way to keep the capital key intact (the ECB seems intent on this), but also alters the amount of stimulus by manipulating financial conditions via a country's yield curve. This could even become country specific if the ECB were to get past the interpretation of its brief that its remit is euro-wide.

However, given this necessarily means country-specific judgements, it will still run the risk of political and/or geographical bias.

Can you imagine the clamour if the Italian Draghi were to ok changing the maturity profile of Italian purchases? Further, if in buying more long-term BTPs this lowered Italian government financing costs, might this not let a government off the hook on structural reforms and encourage the sort of profligate spending certain administrations have been accused of? 

An advantage, however, would be to tighten financial conditions in economies that need this and loosen in those that where economic growth is slowing. Amongst all this, a reinvestment discussion might need to consider what represents the bigger threat to economic and financial stability. That is, slowing economic growth and the sovereign debt-bank doom loop alongside maybe the irrevocability of the single currency versus the ECB’s Euro-wide remit interpretation.

Marcus Dewsnap is Senior Editor/Analyst at Informa Global Markets.

  

  

 

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