Does the ECB Matter?
Some think the ECB could cut interest rates and boost economic activity in Europe. Financials disagree.
-- Samuel Beckett
In my last writing, I brought attention to ongoing deflationary pressure which remains a big problem for Europe overall. Stocks have had an impressive run for most of the EU, which has resulted in a pricing out of firesale distressed sentiment and allowed for an economic recovery on the heels of confidence returning to the area. Hope is rising that the European Central Bank will cut rates as calls for more stimulus and easy money grow. This assumes, however, that a further decrease in the cost of money will make any kind of a meaningful difference when rates are already near the zero line.
The ECB has indeed mattered from the standpoint of cutting off what's called “tail risk” from Europe by promising to do whatever it takes to prevent a Lehman repeat. Other than that, though, evidence points to failed policy. Inflation is exceedingly low in Europe, the euro itself has strengthened, and the nascent recovery could reverse if deflation expectations take a firm hold. The assumption that a 25-basis-point cut would make a difference seems misguided. Indeed, one could argue that by cutting rates further, Mario Draghi is simply getting closer to initiating wide-scale QE in Europe, but in the US it is clear QE has been a bit of a dud in terms of transmission to the overall economy.
Furthermore, surprises are often the most powerful tool a central bank has. It is almost assumed that the ECB will cut rates with 100% certainty. The stock market internally seems to not care though. Take a look below at the price ratio of the iShares MSCI Europe Financial Sector ETF (NASDAQ:EUFN) relative to the Vanguard European VIPERs ETF (NYSEARCA:VGK). As a reminder, a rising price ratio means the numerator/EUFN is outperforming (up more/down less) the denominator/VGK.
Note the far right of the chart, where the ratio has sliced through its 20-day moving average as we approach the ECB's rate decision. It should be considered a warning sign when Financials underperform overall beta into a central bank meeting, as it suggests money is doubtful that monetary action will increase lending, inflation expectations, and economic growth. From this perspective, it appears the ECB does not matter for markets.
Deflation expectations are notoriously difficult to reverse. Ask Japan if you don't believe me.
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