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Is the ECB easing too early?
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Is the ECB easing too early?

Moritz Sterzinger Weekly bulletin September 2019
Euro interest rate markets are pricing in a rate cut by the ECB at its next policy meeting on 12 September.

The current Euribor forward curve suggests that the ECB will eventually take its deposit rate from its present level of -0.40% down to -0.75% over the next two years. In addition, it is widely expected that further monetary stimulus will follow, for example in the form of another lending programme and a new round of quantitative easing (QE). To underline its commitment, ECB officials have recently stated that rates will (once more) remain “lower for longer”. How long exactly? Markets seem to expect “very long” with the 20-year swap rate trading barely above 0%.

Looking purely at interest rates markets, one would get the impression that the Eurozone has turned “Japanese” and entered a prolonged period of low growth and deflationary pressures that call for indefinite accommodative monetary policy by the central bank. This is astonishing, given that only a few weeks ago markets were much less pessimistic about the economic outlook as evidenced by the development of the 10-year swap rate, which fell off a cliff at the start of August (see chart).

It is true that the economic picture has been worsening for a while now. Trade disputes remain unresolved, and Italy’s slow growth and indebtedness continually pose a large downside risk – as does Brexit. Moreover, Germany, Europe’s largest economy, is flirting with recession.

No Armageddon, just yet

However, Germany’s slowdown comes after a long expansion that has led to record employment levels. France, the Eurozone’s second largest economy, is growing at a decent pace. Having been cause for concern in the not-too-distant past, Spain and Portugal are now doing quite well. Overall, inflation in the Eurozone is running at 1% – in line with what inflation-linked bonds are pricing in for the future. Admittedly, this is still a good way off the magic 2%-inflation mark central banks target, but it is hardly on the cusp of deflation. Finally, unemployment in the Eurozone has now fallen to 7.5% – a level not seen since before the 2008 crisis. To sum up: while not necessarily in rude health and as vulnerable as ever, the euro area doesn’t seem anywhere close to the economic and financial armageddon that beckoned in 2008 and 2012, when the Eurozone faced a real risk of disintegrating.

This begs the question why the ECB feels so compelled to provide additional stimulus at this moment. It seems as if the ECB is breaking the glass before an actual emergency has happened. I am the first to admit that the interventions in 2012 and the QE programme introduced in 2015 were necessary to preserve the common currency and ease the burden for highly indebted countries. However, to a casual observer it seems that the situation has greatly improved since, and hence I struggle to see the case for another bond buying programme. By announcing such wide-ranging measures in the absence of a full-blown crisis, one wonders what Mme Lagarde will do when faced with a real recession. It also provides another pretext for politicians to sit back and postpone fiscal reforms that address the fundamental flaws of the common currency.

How effective is cutting interest rates?

Even more contentions than another round of QE is the potential decision to take interest rates further into negative territory by cutting the central bank deposit rate. The effectiveness of interest rate cuts as an economic stimulus is contested. After more than four years of negative rates and not much to show for it in the way of growth, the adage that cutting interest rates is “like pushing on a string” rings very true. Recent research from the University of Bath contends that negative interest rates have reduced bank lending rather than encouraging it. Doubling down on a mostly exhausted toolkit, the ECB seems poised to inflate financial assets further while doing little to create actual growth and inflation. That said, if the European Central Bank was serious about creating inflation, it should resort to “helicopter money” and write cheques for Euro area citizens as recently suggested by a European think-tank.

I for one am puzzled by the ECB’s intention to up the ante and provide further accommodation at this present moment. And I am equally bemused by markets pricing in below zero euro rates for the next decade to come. It is a bet I wouldn’t take.

For more information, please contact Moritz Sterzinger, Director at JCRA, at moritz.sterzinger@jcrauk.com.

 

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