The European Central Bank’s December meeting was a massive disappointment as far as markets are concerned.
Even before President Mario Draghi stepped up to talk about the central bank’s decisions at the press conference on Thursday, the euro had started to climb in value and stocks were sinking.
The ECB cut its main interest rate from -0.2% to -0.3% and extended the hypothetical end of its quantitative easing programme from September 2016 to March 2017.
It also agreed to reinvest any maturing bonds that it had bought under the QE scheme, but didn’t increase the actual amount of the purchases — currently it’s aiming to buy €60 billion ($64.91 billion, £43.08 billion) per month.
The ECB driving down interest rates and boosting QE would usually weaken the euro — Goldman Sachs even expected it to drop from about $1.056 to $1.03 on the day, before falling to parity by the end of the year.
What actually happened was the biggest one-day rise in the euro-dollar exchange rate since 2009:
The FTSE Eurofirst 300, which covers 70% of Europe’s market capitalisation, dropped by 3.3%, the biggest decline since August.
There are a couple of theories about why this happened, neither of which bode particularly well for people who think the ECB should have boosted its easing programme further.
The weak Draghi theory
The first theory is pretty simple. Draghi did want a bigger push, including the rate cut he got (and perhaps a deeper one) paired with tens of billions of euros more in monthly payments.
He tried to pressure the governing council into agreeing with him during his October and November comments, and made the case for it in the early, informal parts of the meeting, but was overwhelmed by opposition. That could either be because there was an actual majority against him, or because he simply wasn’t willing to upset or frustrate representatives from particular countries.
This whole idea is reinforced by a Reuters report, which says that Draghi and ECB chief economist Peter Praet encountered more resistance than expected during the meeting.
One source with direct knowledge of the situation interpreted Draghi’s public stance ahead of the meeting as trying to pressure the Governing Council to take bigger action.
“Draghi raised expectations too high, on purpose, and attempted to paint the Governing Council into a corner,” the source said. “This was problematic and he was criticised for this by several governors in private.”
Unlike last year, when opponents of quantitative easing made their stance public before the decision, the hawks mostly worked behind the scenes.
If that’s true, it probably means two things — less ECB easing in the future, and perhaps a little less trust in Draghi’s statements. If he’s not either voicing the opinions of the governing council of the ECB, or able to convince them of his own opinion, that leaves him in a weaker position.
The incompetent Draghi/incompetent market theory.
The second theory supposes that Draghi was signalling what came in December during October and November, and that he either oversold it, or markets overreacted. The latter is certainly what Jan Smets, Belgium’s central bank governor, seemed to be saying on Friday.
It’s supported by a Wall Street Journal article from Brian Blackstone, which suggests that Draghi did not formally push for any further stimulus on top of what was announced during the ECB decision-making process.
This theory depends whether you think the onus is on Draghi to communicate accurately, given how the market actually reacts, or whether you think he’s not responsible for hyperactive expectations. Either way, it’s bad news for future ECB easing, because it implies that Draghi doesn’t have as much of a dovish view as people expected.
The weak Draghi theory seems more plausible than the incompetent Draghi theory. By November 19, analysts at investment banks like Deutsche Bank, HSBC had already forecast the 0.10 percentage point cut in the deposit rate. Capital Economics had forecast a €20 billion ($21.63 billion £14.35 billion) addition to the ECB’s QE programme. Goldman Sachs analysts were referring to “the potential for the ECB to ease aggressively in December.”
So when Draghi stepped up to speak on November 20, it seemed that a lot of analysts (and maybe the market) were already prepared for a 0.1 percentage point rate cut in December. In Frankfurt, Draghi gave what was interpreted by everyone with ears as an even more dovish intervention. Here’s the kicker:
We consider the asset purchase programme to be a powerful and flexible instrument, as it can be adjusted in terms of size, composition or duration to achieve a more expansionary stance. The level of the deposit facility rate can also empower the transmission of APP, not least by increasing the velocity of circulation of bank reserves. If we decide that the current trajectory of our policy is not sufficient to achieve our objective, we will do what we must to raise inflation as quickly as possible.
The speech was likened to Draghi’s mid-2012 speech, when he used the now-famous “whatever it takes” phrase, referring to the ECB’s willingness to intervene and quell the bond market’s panic over the idea that the eurozone would break apart.
After the speech and before the December meeting, Societe Generale, Daiwa Capital Markets, Bank of America Merrill Lynch, Goldman Sachs Asset Management and others were suggesting a material increase in the size of the monthly QE purchases. A note from Jefferies on November 30 summed up that mood (emphasis theirs):
Even two weeks ago we were less convinced of a deposit rate cut on 3 December, putting more weight on the ECB speeding up the bond buying and possibly extending out the eligible assets they can buy. However, recent comments and the subsequent price action — which the ECB has done nothing to counter — makes it more likely the ECB goes all in. €80bn of bond purchases a month, with a tiered deposit rate with -0.4% on excess reserves.
Some analysts kept their previous, more modest forecasts, but many overshot. As much as the ECB says that it’s not its mandate to meet market expectations, this is an important part of forward guidance — central banks around the world have been doing more than ever to try and ensure that nobody gets any nasty shocks.
Despite Draghi’s suggestion that the ECB would act to move inflation back to target (close to but below 2%) “quickly,” there was no upgrade to the eurozone inflation forecast. The ECB expects inflation of just 1.6% by 2017:
To believe the theory that the market or Draghi was incompetent, you’d have to agree with at least one of these things:
- Draghi doesn’t care about missing market expectations by a considerable margin.
- Draghi didn’t know his speech would be interpreted as even more dovish than his October comments.
- Draghi and his economists don’t keep up with what analysts are expecting from the ECB.
To me, none of those seems entirely plausible — which means the weak Draghi theory is a more reasonable explanation.
The only other possibility, as the Telegraph’s Ambrose Evans-Pritchard has suggested, is that the market is just flat-out wrong (as it was at the time of Draghi’s “whatever it takes” speech), and it’s underestimated the amount of easing that was pledged. That’s more or less what Draghi said himself on Friday, insisting that the timeline extension and re-investing of QE purchases would add €680 billion (£488.24 billion, $735.56 billion) in liquidity by 2019.
But markets weren’t convinced — the euro is currently at just above $1.08, still well above where it was on Thursday morning.
As it stands, neither of the big theories is good news for anyone who thinks the eurozone still has a considerable demand problem, and that there’s more the ECB can do.
Either Draghi simply isn’t the QE-happy central banker that some believed, or he’s had his hands tied by other governing council members.