Unorthodox monetary policy since the post-financial crisis has always generated controversy. To ensure economic and financial stability during the financial crisis central banks expanded their tools to deal with extreme risks. Since these tools are generally outside the scope of traditional modern economic theory, tactics such as negative interest rates and quantitative easing are accused of distorting asset markets.
The ECB manages three key interest rates main refinancing operations (MRO), the rate on the deposit facility and marginal lending facility rate. In times of calm, it’s the deposit facility at -0.40% which captures the market attention although the main refinancing operation is used most often to provide liquidity into the banking system.
With monetary policy stuck at extremely loose levels, the direction of policy action is less clear. Historically, with all things being equal, the direction of inflation was the primary input for deciding policy mix. Higher inflation expectations would trigger higher policy rates (and vise-versa). With ECB policy still at extraordinary positioning, would suggest that policy setting moving forward have a higher discretionary aspect. Hence, ECB chief succession is of critical importance.
The ECB has moved towards a more dovish bias as the regional economic outlook has deteriorated and inflation expectations are fading. Draghi’s recent comments suggest significant probably of monetary policy action in July. After that point, the Governing Council will not meet again until September. One can argue the ECB efforts to achieve their price stability mandate have been exhausted and the next policy direction will be based on the personal philosophy of the primary decision maker.
To take over the ECB helm, early bets were skewed towards Jens Weidmann the Bundesbank president. Given his hawkish stance and German economic lean, we would anticipate a shift in ECB predisposition (i.e. less extreme measures benefiting low growth EU nations). However, Christine Lagarde is now in the pole position to head the ECB. Lagarde with her strong personality and solid global republicans will likely continue Draghi policy, which supports weaker peripheral European nations. Her appointment, which still needs to be approved by the European Parliament, would likely bring a new prescription of accommodative monetary policy. A policy package mix of negative Interest rates, new TLTROs, and asset purchases is coming with Lagarde at the head of the ECB.
Global yields have fallen expectation of weak economic outlook and anticipating additional ultra-loose monetary policy. Yet yesterday saw European yields drop sharply as Lagarde’s historical preference for stimulus made an impression on bond markets.
Across the continent, short-end yields are now below zero. German 10 yr yields fell to a new all-time low at -0.397 (just a sliver above ECB own deposit rate) while France's 10 yr yields reached -0.10. While bondholders are being crushed, we should see further rotation into SMI and global equity markets. The mad search for yields has been reignited.
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