Mario Draghi and the ECB have a habit of patting themselves on the back when it comes to what they imagine the happy outcomes of their monetary policy decisions have been. In fact, they have a habit of congratulating themselves on positive outcomes even before said outcomes have been observed or have even had time to play out.
On the one hand, that sends a message to the market that the central bank has a lot of confidence in its own omnipotence and indeed, Mario Draghi is famous for executing one of the most successful examples of jawboning in the history of central banking when, after proclaiming at the height of the eurozone debt crisis that the ECB would do “whatever it takes”, he forestalled the ECB’s “emperor has no clothes moment” for at least two years.
On the other hand, congratulating oneself for things that haven’t happened yet risks palpable embarrassment should things not turn out the way you thought they would and that, ladies and gentlemen, is precisely where Mario Draghi finds himself going into tomorrow’s ECB announcement which the market will be watching closely, and not for confetti attacks, but for hints (or even an announcement) of more QE.
Why would the ECB expand QE you ask? Well, first because PSPP really hasn’t worked, despite Draghi’s protestations, and second because, as we noted yesterday [11], “the only thing that can offset the synthetic inverse QE that China and/or the rest of the EMs embarked on as Zero Hedge first warned last November, is more quite tangible QE conducted elsewhere, ideally at the ECB (which is currently 6 months into its first QE episode), or Japan (although the ceiling to debt monetization there may have been already hit with the BOJ already monetizing more than 100% of all gross issuance) but not the Fed, whose rate hike intentions are what started this entire global reserve liquidation fiasco in the first place."
But don’t take our word for it, just ask Citi who isn’t mincing words when it comes to the ECB’s failure to boost inflation expectations and forever vanquish the deflationary bogeyman.
“The failure of the current ECB QE programme looks clear,” Citi says, before offering the following explanation for that rather heretical assessment:
Inflation expectations have collapsed across the short term and long term. The Draghi ECB has been characterized by a cycle that starts with a defense of the prevailing policy, then moves to an eventual policy reaction, later followed by assuredness on what has been achieved. That assuredness, most recently highlighted in Draghi’s June press conference when he dismissed bond market volatility, should now give way to a sense that economic events have not played out as expected in our view. This should be reflected in downward revisions in ECB staff forecasts for growth and inflation.
So there, summarized, is the ECB QE failure bit. Now, here’s Citi's bullets on why Mario Draghi may be first up to bat to combat the effect of EM FX reserve drawdowns:
- The decline in currency reserves has been notable since Sep-14, and averages nearly $60bn per month.
- The evolution in balance sheets is important for real rates. Figure 16 highlights the change in 5y5y real rates versus change in balance sheet size.
- Forex reserve unwinds are important – but so are central bank balance sheet expansion. Academic research suggests a 1% of US GDP decline in either case results in +30bp 10y UST.
- Figure 17 models the current state of play where we factor in global central bank balance sheet and reserve moves. Real USD 5y5y is close to fair.
[12]
And here’s Citi, summarizing: “it seems reasonable to expect Forex reserves to decline, in which case central banks will face a meaningful tightening in monetary and financial conditions [and] markets should therefore be also alert to central banks offsetting these reserve flow impacts should the current dynamic of modest growth and weak inflation persist.”
But the punchline, as we detailed on Tuesday evening [13], is that EM flows are no longer correlated to G3 balance sheet expansion. Instead, they're tracking the Fed's balance sheet alone.
[14]
What that means is that no matter what Mario Draghi does, quantitative tightening will continue unabated until the Fed realizes that it missed its rate hike window and must now at the very least not hike and if it wants to prevent an outright EM meltdown and the attendant loss of global liquidity, will need to launch QE4 - and in a hurry.
