ECB: Between a Rock and a Hard Place?
Amid waning momentum in business surveys of late, most notably in services, the ECB was starting to see some of the downside growth risks it has flagged actually start to materialise. But the equity market slump now unfolding provides an added and significant downside risk. It has direct adverse repercussions on wealth (and thus spending); adds to services fragility; may make banks (already wary about risk) less willing to lend and may have spill-over effects into sovereign spreads. At this juncture we think it premature to change our long-standing official rate outlook which in case came with a health warning of further and/or faster easing. But the fact is that events in Asia and the U.S. may be making the ECB’s main concern of a monetary policy transmission mechanism working more forcefully, all the more likely.
The source of the current equity selloff is manifold both in terms of events and market-specific shifts, not least what were already highly leveraged positions Based around the presumption of low volatility. Clearly the BoJ hike and inter-related Yen surge is reverberating strongly, as are seemingly weak U’S’ labor market data and what have been underwhelming financial results from major tech companies, which prompted concern that the huge investments in artificial intelligence were not paying off. For the ECB, it may find it ironic that the EZ is thus being buffeted by events in Asia and America and not Europe. But his would be too simplistic.
EZ Spill-Over Risks
For a start, the EZ is not immune to its own fragilities, amid an unprecedented hike in official rates that has only just started to unwind. But the formal rate hikes came alongside a tightening in bank lending standards that meant the EZ was facing a reduction in the supply of credit as well as a rise in costs. Indeed, given that the EZ economy is much more dependent on the bank lending channel than credit markets compared to other DM economies, this is why we have suggested that the ECB hiking action was not only extensive but also excessive. It is notable in this regard that the last ECB bank lending survey was still pointing to companies facing tighter credit, but this is all the more notable as the prime factor was banks perception and tolerance of risk. This can only get worse still unless markets settle down – which cannot be ruled out.
This could be amplified if sovereign spreads continue to rise as markets flee risk, this all the more important as the ECB may not be able to use its TPI mechanism as many of countries involved are now facing excessive deficit procedures from the EU. Admittedly, we would suggest this risk is low given that the actual level of sovereign yields has fallen so clearly, to a degree that if the ECB were to run its September-planned projections today, it would involve interest rates assumption some 50 bp-plus lower than those in June. All other thing constant this may mean higher growth and inflation projections but of course this ignores both the sell-off seen in commodities (most notably energy) and the risks to growth, both directly to the EZ as but also from a weaker and/or more fragile global economy.
EZ Longer-Standing Downside Risks
But there is also the EZ’s own fragility, this being something we have flagged repeatedly as we have suggested over-optimism from the ECB regarding growth. Admittedly, the ECB may be satisfied with the two solid quarters of near-trend growth seen so far this year and the fact that a forma recession has been avoided. But this masks a divergent backdrop which is likely to see Q2 see a sixth successive q/q in goods production, against the continued growth in services - a divergence that helps explain the growing disparity in the real economy backdrops of the main EZ individual economies. Bu even before this market sell-off, there were growing signs of services slowing from business survey data. Indeed, the PMI numbers suggested that this was partly due to export business shrinking at the quickest rate in five months – NB the European Commission services data is even weaker!
Watch This Space
ECB policy makers who may be making frantic calls from wherever they may be holidaying, both to each other and to central bankers elsewhere. For the moment, this priority will be in maintaining market liquidity and will note that a sharp selloff early last year based on banking worries proved fleeting. But the focus on inflation, amid only limited concern of economic risks, may be about to change.