Scotiabank Expects A Dovish Draghi, But Markets Will Be Disappointed

Via Scotiabank's Guy Haselmann,

Draghi’s Difficult Dance

Draghi’s clever Jackson Hole speech unleashed financial market expectations of additional stimulus measures at Thursday’s meeting.  However, the situation is complicated.  Thus, numerous interpretations have unfolded on what he signaled (or didn’t signal) and on what types of ECB-led solutions are possible. Some pundits have argued that large-scale QE for Europe would do more harm than good.  Regardless, markets are likely to be disappointed as the October meeting seems to be a more practical time for any announcement.

Draghi further complicated quarrels by saying that such a program would ultimately not be effective without action that occurs in parallel with fiscal changes. In his concluding remarks, for example, he said that “a coherent strategy to reduce unemployment has to involve both demand and supply side policies, at both the Euro area and the national levels.”  (some have referred to this as Draghi’s three arrows)

He was basically telling politicians that the stance of Eurozone fiscal policy needed to be re-examined.  His New-Keynesian framework probably did not go over well in Berlin.  It was leaked in the German press that Merkel called Draghi after his speech.  He might have chosen to lecture politicians, because of his tacit acknowledgement that the economy is facing a liquidity trap;  implied by his comment, “due to the zero lower bound constraint, there is a real risk that monetary policy loses some effectiveness in generating aggregate demand”.

Draghi is a savvy political operator.  He is fully aware of the limitations and consequences of a sovereign debt QE program.  He knows that a central bank’s willingness to purchase a country’s debt (in ‘whatever –it-takes’ quantities), basically places an implicit cap on the price of a country’s funding.  Such a program rids a government of fiscal discipline, while simultaneously eliminating the spikes in yields that would normally result.  Complacency or fiscal stalemate ensues; enabled specifically by monetary actions.

Could this offer a partial explanation why Portuguese 10 year yields have fallen from 15% in 2012 to 3.22% today, while its Debt-to-GDP has steadily risen (64% in 2007, 84% in 2010, 108% in 2012, and 129% in 2014)?

After many failed years of trying to attain fiscal reforms in Brussels and at the Nationals’ level, the ECB is unlikely to receive any near-term fiscal help (due to austerity-drive and fiscal targets).  Therefore, the ECB will ultimately have to go-it-alone, despite questionably effective tools.   Europe is in dreadful and deteriorating shape, so the ECB does not want to be viewed as not doing enough: Draghi said, the risks of ‘doing too little’, outweigh those of ‘doing too much’.  Consequently, when the ECB reaches the point of desperation, its key objective will become to merely ‘buy time’.

It could easily be argued that markets have already taken yield levels to record lows; so markets have already done the job for the ECB.  An effort to lower them further would have little, if any, impact on aggregate demand (a classic liquidity trap).  However, the critical channel at this point for the ECB (to glean economic benefits) is through the weakening of the Euro.  Therefore, the ideal time to expand its balance sheet may be at the same time that the Fed’s balance sheet flat lines, i.e. at the ECB’s Oct 2nd meeting.  

Draghi noted in his speech how inflationary expectations had become unanchored; a condition previously identified as a potential catalyst for a broad-based QE program.   This extemporaneous part of his speech might have been directed at the Bundesbank in an attempt to gain its support.

Draghi’s statement about the short fall in demand was recognition that real interest rates are still too high.  Markets need to remember however that the ECB recently announced negative deposit rates, targeted longer-term refinancing operations (TLTRO), and plans for purchases of asset-backed securities.  These programs will take time to have influence and take time to be fully implemented.

I expect Draghi to be dovish on Thursday, but it likely too presumptuous to expect any new measures.  I suspect the ECB will eventually be forced (reluctantly into the QE revelry).  The main goal will be to weaken the Euro.   Equities and periphery sovereign spreads are probably already fully-priced for a QE program.  Bund yields and inflationary expectations will likely rise on the announcement (real yields will fall).  

The US/Bund spread will likely become less negative and drop from -148 today toward -100 bps.

“I came in from the wilderness, a creature void of form.  “Come in”, she said, “I’ll give you shelter from the storm”. – Bob Dylan