European Central Bank has acted strongly to combat deflation

Sarkaritel
By Sarkaritel June 6, 2014 15:46

European Central Bank has acted strongly to combat deflation


The markets began 2014 looking to move in the direction of how two underlying themes play out – the “great rotation” and the “great normalisation”. Asset managers were bullish on equities. Since the financial crisis, money had largely been pumped into debt and as a gradual recovery gathered pace, this “great rotation” would push equities higher (above their 2013 highs) as money flowed from bonds to stocks.

Closely connected was the “great normalisation” with the announcement by the US Federal Reserve to taper its quantitative easing program in May, 2013, it was a sign of confidence that the zero interest rate policies (ZIRP) and unconventional monetary policy tools had worked and put the US economy on a sustained economic recovery trajectory.

The “risk-off” trade soon became the “risk-on” trade.

Currency Corner has been arguing over the past many weeks that the Euro zone recovery could not be sustained due to the low inflation and that the central bank would have to act to depreciate the Euro. ECB president Mario Draghi lived up to the market expectations by cutting its deposit rate to minus 0.1 percent.

This is a historic move and the ECB has become the first major central bank to move its deposit rate in the negative territory. This step in effect means that financial institutions will be charged for parking their funds with the ECB.

It lowered its key interest rate to a record 0.15 percent and the marginal lending rate was cut to 0.4 percent. He added that interest rates were at the zero bound which effectively means that we should not expect any more rate cuts here onwards.

Although the central bank did not announce outright QE, it took a step in the right direction by promising to deliver a massive stimulus package. It was announced that more loans would be used for the long term refinancing operations (LTROs). Further, two targeted long term refinancing operations (TLTROs) of initial size of 400 billion euro in September and December were announced.

The strerilisation of securities market program was ended as expected. The most dovish tone was used by Draghi when he said “we’re not finished”. He expected moderate growth in the second quarter but acknowledged that the outcome could be weaker than expected. The ECB staff projection for 2014 GDP was revised downward and Draghi reiterated unemployment remained high and unutilized capacity was still sizeable, despite labour market improvement.

The Euro touched a four-month low of 1.35 against the US dollar in the build-up to these announcements before climbing its way back again in positive territory above 1.36. This was expected as the EUR/USD currency pair had been drifting lower in the past couple of weeks on expectations that the ECB would indeed do “whatever it takes” to combat deflation.

The German equity benchmark, DAX, climbed above 10,000-point mark for the first time as the Euro tumbled which would revive the export giant.

After the Federal Reserve taper, the Bank of England’s forward guidance to raise interest rates and the Reserve Bank of New Zealand (RBNZ) becoming the first major central bank to raise rates, the regime of easy liquidity era seemed to be coming to an end.

This shift towards the “new normal” will take some more time now with the ECB announcing the above measure as also a high degree of probability towards more monetary stimulus out of Japan.

Over the next few quarters, we can expect to see the euro slip towards the 1.3 key support against the greenback. The current account surplus, net positive fund flows into the euro zone and low periphery yields do support the Euro bulls. But in the short term it would be hard to fight the dovish stance of the ECB.

Sarkaritel
By Sarkaritel June 6, 2014 15:46