Credibility of Central Banks – A comprehensive analysis of ECB and FED effectiveness

Credibility of Central Banks – A comprehensive analysis of ECB and FED effectiveness

On the 1st of January 1999, the ECB assumed responsibility for monetary policy in the euro area, with the primary objective of maintaining price stability, keeping the euro area’s target inflation rate (calculated using the Harmonized Index of Consumer Price, HICP) below, but close to 2% over the medium term. This objective has even been reinforced with the ratification of the Lisbon Treaty in 2007. Seventeen years later in 2008 the global financial crisis erupted causing the greatest economic recession since 1928. Since then the ECB has been put under additional pressure to advise on regulation and enforce banking supervision while fostering economic growth. Extremely unconventional monetary measures have been taken to achieve this objective and a recover of the economy and productivity.

On the 12th of November 2008, the first measure was implemented by cutting the interest rates for deposits, overnight loans and the Main Refinancing Operations. The two main objectives of this move were to provide greater liquidity to commercial banks and depreciating the currency against the US dollar, allowing a greater competitiveness.

Despite the large amount of capital lent through MROs and LTROs, banks preferred to buy bonds instead of lending to families and enterprises, not fulfilling their function as middleman between the ECB and the real economy.

On the 26th of July 2012, Mario Draghi famously announced that the ECB was willing to do “whatever it takes”. Consequently, launching new measures to support the countries, which were facing economic and financial difficulties. In September of that year the Outright Monetary Transactions (OMT) were introduced.

The OMTs key points were: Unlimited ex-ante bonds purchase quantity; one-year and three-year maturity bonds purchase; transactions performed in the secondary market sterilizing the exceeding liquidity. While this programme was initially controversial, as it questionably occurred outside of the ECB’s legal framework, it did achieve its expected outcomes, as bond yields in the weaker countries declined. On the 5th of June 2014, the ECB announced the first series of TLTROs (Targeted Long Term Refinancing Operations) which linked the amount borrowed and lent (expected mortgages) to private sector, aiming to incentivize banks to increase their lending.

Although the ECB had implemented all these unconventional measures, no significant positive effect had been seen.  The PMI index evolution show a soft recovery ignited by Draghi’s first moves.

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That is why on 22nd January 2015 Mario Draghi introduced an extended Quantitative Easing program, the Asset Purchase Program (APP), which allows the purchase of Eurozone government bonds. This programme allowed for € 1,140 billion in bonds to be purchased and lasted 19 months (supposedly, from March 2015 to September 2016), injecting even greater liquidity into the market. The bond purchases provided greater monetary stimulus to the economy while the key ECB interest rates were kept at their lower bound. Furthermore, an easing of monetary and financial conditions occurred, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately aims at helping the economy reach its targeted inflation rate. This move was unexpected from market who rejoiced vigorously, pushing European stock indexes up to multiyear highs. DAX index, the one who benefited the most from the ECB’s new plan topped 12000 points.

After one year of the extended QE program some doubts arose about the effectiveness of the ECB’s monetary policy, raising the credibility of monetary policy issue and igniting criticism from some member states, such as Germany, mainly for the negative impact on people’s savings.

In response, the ECB surprised the markets in March 2016, by cutting key interest rates, expanding the asset purchase program to 80 billion monthly and deferring the end to March 2017. In addition, the percentage of bonds that can be purchased has changed from 33% to 50% and the purchase program includes also some high-rated companies’ shares other than covered bonds and asset-backed securities. Four new TLTROs (TLTRO II) are being issued every three months, starting from June 2016 with an interest rate, which is linked to the participating banks’ lending patterns. The more loans that participating banks issue to non-financial corporations and households (except loans to households for house purchases), the more attractive the interest rates on TLTRO II borrowings becomes.

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In a recent statement at the ECON committee of the European Parliament on the 28th of November, Mario Draghi remarked that: “To increase the effectiveness of monetary policy, fiscal and structural policies are needed that reinforce growth and make it more inclusive”, while in his speech ten days before, stated that “Since the onset of the global financial crisis, 2016 has been the first full year where GDP in the euro area has been above its pre-crisis level. The economy is now recovering at a moderate, but steady, pace, while the employment is growing. We remain committed to preserving the very substantial degree of monetary accommodation, which is necessary to secure a sustained rise in inflation.” Despite Draghi’s reassurances, as well as the unconventional and largely expansive measures carried out by the ECB, one can observe that inflation levels are rising, but still at a too slow pace, currently at 0,5%. The same can be said for GDP growth.

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The main question to ask is where is large amount of capital that is being injected into the economy flowing, and why is it not boosting growth?

Low interest rates – the rate on the deposit facility is -0.4% while the interest rate on the main refinancing operations is at zero level – should decrease the cost of financing of the banks and lower the attractiveness of government bonds inducing them to lend to enterprises and consumers. Unfortunately, many factors have contributed obstructing the transmission of money to the real economy and restrained the banks from granting loans. First, the banks are not inclined to lend money for three main reasons: the poorer margins on loans, squeezed by the rates at their lowest level; the necessity to keep risks under control which conflicts with the credit standards’ tightening, particularly on corporations, that can even be worsened by the forthcoming introduction of Basil IV, still under discussion, which is considering to impose the use of standardized credit scoring approaches, instead of the more flexible Internal Standards-Based Approach introduced by Basil II, change which will require higher provisions for risks; at last the harsher capital requirements set by Basil III in 2013, which induce banks to immobilize funds that could be alternatively lent.

It seems that the situation is getting better and banks are finally increasing the amount of loans granted. It is noticeable that the increase is faster since 2015, year of introduction of the Quantitative Easing program. The manufacturing PMI Index for euro area, which measures the performance of the manufacturing sector, is climbing up to the 2011 peaks. Therefore, the introduction of stricter credit rating approaches is highly questionable and more flexibility should be given to lenders.

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It is also true that the low interest rate policy and the Asset Purchase Program have contributed to the increase in prices of assets and so the reduction of yields, inducing banks to take greater risks in return for higher returns. Indeed, fixed income prices are at their highest while the German 10Y bond yield is only 0,2%, having been even negative last June for a couple of months. 

Another reason behind the lack of effectiveness of the quantitative easing is that it could not have the impact desired, as interest rates at the inception of the program were already very low. The 3-months Euribor rate was hardly higher than zero.

The conclusion is that monetary policy does little to support growth, when not combined with adequate fiscal and regulatory policies. The IS-LM diagram, or Hicks–Hansen model, can help one better understand the current situation. Last but not least, the world today is in what can be deemed as a “liquidity trap”. A situation in which the central banks cannot reduce the interest rates even further, as doing so has no effect on inflation. Policymakers are pushing negative interest rate policies to stimulate growth. Lower rates are designed to spur savers to spend, redirect capital into higher-return (i.e. riskier) investments, and drive down borrowing costs. This is associated with a weaker currency, making exports more competitive. When a “liquidity trap” occurs and rates go negative, a squeeze on the speed at which money circulates through the economy, commonly referred to as the velocity of money, incurs. Therefore, each Euro generates less and less economic activity, increasing deflationary pressure. As consumers see prices decline, they defer purchases, and growth slows. Deflation also lifts real interest rates, which drives currency values higher. If the ECB persists in this policy, pumping more and more liquidity into the economy, then more negative rates could be on the way.

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The austerity measures pursued by the European Union since the beginning of the European sovereign debt crisis at the end of 2009, have constrained the member states to lower their debts and the public spending, exacerbating the fiscal policy and worsening the economic downturn. By the way, it seems that, under the more insistent demand by many member states for more flexibility, EU is overshadowing the pursuit of lower deficits, to focus on the boost of economic growth.

On the 8th of December 2016, Draghi announced that the ECB would scale back the monthly bond purchases from € 80 billion to € 60 billion in March 2017, postponing the end until December 2017, reassessing the support of ECB to markets. Moreover, the ECB would consider (but not necessarily pursue) purchases of bonds with yields below the standing facilities deposit rate (i.e. -0,40%), thereby incurring losses for the central bank, if such purchases were to be made. This announcement provided a largely positive reaction on the European equity markets, while European bond market yields fell even lower and the Euro/Dollar had its largest drop since Brexit, depreciating by 1.5%. Following the announcement of the ECB’s future QE plans, reporters repeatedly questioned whether and when tapering would occur and Draghi insisted that members of the governing council unanimously did not consider such measures.

Europe, to help the ECB to fulfill its task, is considering several non-monetary measures. The Capital Markets Union (CMU), strongly supported by ECB, is expected to come into effect in 2018. Commercial banks are currently hesitating to issue new credit, particularly to SME’s – which account for 99% of all enterprises in EU – due to the size of their large balance sheets. The CMU would enable commercial banks to shift risks away from balance sheets by allowing investors (such as pension funds) to invest in securitized loans. However, it must be stringently regulated, to ensure that the quality of the debt being securitized and sold, meets certain standards. A lesson tragically learned by the recent financial crisis.

The harmonization of fiscal policies among EU member states seems still far away and hard to achieve. At last Europe is changing attitude in direction of a greater allowance for deficit spending and public debt, under the requests received by many member states, which questioned the austerity policy.

Unconventional and expansionary monetary policies have been implemented by the ECB in the past years in response to one of the greatest recession in history. The traditional policies are no longer effective and the Central Bank is now experimenting new solutions, which are contributing to the recovery, even if the results are not as good as expected and Europe has not recovered the pre-crisis economic level yet.

European bodies and the ECB are struggling to boost the economy and to increase the cohesion within the European boundaries through a process of continuous change.

However, many are the threats to the future of Europe. The forthcoming elections in France, Germany and perhaps Italy, on the wave of anti-European and nationalist movements, are likely to increase the uncertainties about the solidity and cohesion of the Union, even more after the stunning result of Brexit referendum. Cohesion that is already under pressure and exasperated because of the different interests and views of the member states about serious issues currently under discussion such as the actions to adopt in response of the massive migration wave that is hitting EU borders (and that can even worsen given the current tragic situation in Syria) or the necessity of austerity policies.

Second, the possibility that the extremely expansionary measures can lead to excesses and to a financial bubble likely to explode once there would be a tightening of the policy (house prices in healthier countries are rising sharply).

Furthermore, the effects of the enhanced divergence between the monetary policies pursued by the ECB and the Fed are still unknown and unforeseeable. The Fed has not surprised investors with the last adjustment on December, even if the signal sent by Janet Yellen was little more hawkish than market is used to. The immediate effect has been a strengthening of the dollar against other currencies and a sell-off European bonds, which showed a rise in yields. The Fed funds futures show that traders are now betting on a faster tightening by US Central Bank. Indeed, the Chairman has announced that there will be at least three more adjustments in 2017. It seems that the era of ultra-low yields is nearing its end in USA, where the economy is recovering strongly and even better are performing the financial markets (Wall Street has reached its historical peaks).

The effects for Europe are difficult to predict, but for sure, the quicker the dollar strengthens, the more destabilizing that is. For instance, a huge amount of emerging countries’ bonds is issued in dollars, thus it would be harder to repay it Moreover many commodities are priced in dollars so they would become much more expensive contributing to a slowdown of global economic activity that depends on the consumption of such resources, on the oil price, which is now recovering after having hit its lowest level at the beginning of 2016.

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The ECB is dealing with a testing challenge: achieve a recovery of the European economy and productivity within a global environment characterized by slow economic activity and great uncertainties, while experimenting policies never pursued and whose results are difficult to predict. The difficulties and the threats that can obstacle the fulfilment of the mission are many, so are the opportunities that can be taken. There are too many uncertain factors that make useless and speculative every effort to make predictions. Draghi, which will be in charge until 2019, seems to have clear ideas about how to deal with the task and has already achieved very good results, despite the critics.

Would the ECB and EU bodies be able to face the forthcoming hard times, keeping the EU unity and cohesiveness and achieving finally the economic recovery? Stay tuned.

Author:

Conor Marriman, Niccolò Ricci and Alessandro Sicilia

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FINANCIAL MARKETS: WHERE WE ARE AND WHERE WE ARE GOING

FINANCIAL MARKETS: WHERE WE ARE AND WHERE WE ARE GOING

Having a look at some of the biggest winners and losers on the global financial markets in 2015, Jamaican stocks result to be among the top performers; the island nation’s index rose more than 80 percent. As for losers, the political issues and lower oil prices have hurt the Ukrainian equities index, which has tumbled 56 percent year-to-date.

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At the same time, on the developed Market, Eurozone equities enjoyed some rallies in 2015, buoyed by the ECB’s bond buying and the weak euro. In terms of local currencies, Europe’s benchmarks did well this year. Investors greeted Italy for finally dragging itself out of a triple-dip recession, but in Spain, fears of political impasse outweighed the excitement surrounding its economic recovery. The commodity rout hammered London’s FTSE 100 as it went down 4.8 per cent on the year.

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Had it not been for a small group of nifty companies, 2015 would have entered the history books as a terrible year for the US stock market.

The consumer discretionary sector led the way this year, followed by healthcare. However, energy and materials companies were the biggest loosers due to the decline in price of many commodities. Yet there were some very positive numbers for a group of four companies that have come to be known as the “Fangs”(Facebook, Amazon, Netflix and Google) and for a wider group that included Microsoft, Salesforce, eBay, Starbucks and Priceline to create the “Nifty Nine”.

Both groups gained more than 60 per cent throughout the year.
Part of the reason for that was that profits were declining. This was in large part due to decreasing revenues at energy companies, driven by falling oil prices. But the strong dollar, which hit overseas earnings, was also a factor. In the same manner declining margins played a key role, as wages started a slight recovery. Therefore investments flow mainly to the enterprises that can show strong revenue growth. That is extremely worrying.
Dominance by a few big companies is a symptom of the end of a bull run, as it happened in the early 1970s (dominated by the “Nifty Fifty”) or the late 1990s (dominated by the dot-coms).

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The rise of tech startups with extremely high valuations, as well as the ‘FANG’ group of stocks, has generated much concern over whether or not we are in another tech bubble. According to Goldman Sachs, there is one important difference between the confirmed tech bubble we saw in the late 1990s, early 2000s and today. The big difference is earnings.

During the tech bubble, tech companies never accounted for more than 16 percent of the total index earnings. As January 2016, tech earnings contribute for over 20 percent. Regarding the market cap, tech companies’ accounts for a smaller portion of the S&P 500 in comparison with previous years. In fact, as today, the tech industry’s market cap represents only 21% of the S&P index as compared with previous peak figures of 32%. (smaller market cap of S&P 500, higher earning, hence it is less likely the bubble will repeat itself).

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FORECAST AND RISKS

 The US stock market has vastly outperformed the rest of the world after the 2008 crisis, accommodative monetary policy helped this to happen. So did the strength of the US economy, while the strong dollar also amplified the outperformance. Yet a too strong dollar might hit the US companies’ overseas earnings while strengthening the rest of the world, and other central banks are now aggressively easing monetary policy while the US Federal Reserve has just started to raise rates.
The growth gap between the US and Europe is starting to narrow. At this point in time, we are expecting Europe to see GDP growth of roughly 1.75 per cent in 2016, against 2/2.5 per cent in the US. This was mainly caused by the rising dollar price that redistributed growth and corporate earnings from the US to Europe. It would be a surprise if in the second half of 2016, the European economic growth accelerates beyond the US growth. Such a result might produce a year of earnings growth for European listed companies, something which has failed to happen since 2010. Stronger Europe growth would challenge assumptions that very low interest rates have become normal.

The UK is expected to follow the US and raise rates by the end of the year, yet Europe is still cutting them. China’s economic wobble (which has deepened the commodities crisis and by doing so, dragged the FTSE 100 down with it) has depressed emerging markets.

Even the political landscape is shifting. A presidential election in the USA and the European referendum in the UK are creating speculations over what “Brexit” or a Trump presidency might mean for investors. The other main risks for this year are Fed’s mismanaging communication of its process, which could have a destabilising impact on financial markets and another round of deflationary pressure exported from China.

 Moreover the world’s major economies are beginning to diverge. The US was the first to begin the withdrawal process from rock bottom rates, but fears remain about its future growth prospects.

Businesses compete for investor money and also offer corporate debt (bonds) to fund operations. If the rates of Treasuries rise due to Fed action or a spread selloff in the bond market, then a company that wants to raise capital must offer higher rates of return on their bonds offerings. This higher rate of return is a larger burden on their balance sheets and decreases profitability therefore they will have lower EPS. Considering also the higher borrowing rates of businesses and consumers, a general slowdown in corporate profits could arise. This slowdown will result in the liquidation of share holdings in search of better investments.

COMMODITIES

For the commodites sector, 2015 was characterised by a strong downward trend.The worst performers were West Texas Intermediate and Brent Crude oil. Metals, such as platinum and palladium were down by roughly 30% along with gold losing up to 10%.

In agriculture, the coffee fell down by 25%, while it was an upward year for cotton and sugar. The collapse in oil prices during 2015 was determined by the slowdown in China’s economical growth and the unchanged Saudi Arabia’s oil production, which has not decreased in order to stop the business of fracking in America. If oil reserves reach the maximum of their production capacity and the oil demand decreases further down, the oil price will suffer further downward corrections.

The general consensus of the Brent’s price for 2016 is 50$ per barrel, compared to the 29$ per barrel at the moment. Furthermore, Iran, free from sanctions, will add to the current level of world production (95 million barrels per day) half a million barrels per day. Three major investment banks (Morgan Stanley, Citigroup and Goldman Sachs) warned that if oil storages continue to rise, the price might reach a minimum of 20$ in the short term.
However, the decline of oil production in the United States, will counterbalance the levels of world production, creating conditions of getting prices to reach the ones agreed in the consensus. Consequently US WTI crude oil is keeping its outlook at $45 a barrel, while for Brent crude oil at $50 a barrel in 2016. Finally major investment banks analysts forecast gold to remain around $1,100 per ounce for the next three months, $1,050 an ounce for the next six months and $1,000 an ounce for the next 12 months.

London, Jan 19th 2016

Luca Cartechini, Head of Asset Management
Fulvio Abbonato, Asset Management Associate

On the Rollercoaster – Yearly Recap

On the Rollercoaster – Yearly Recap

The 2015 has been a very turbulent year for financial markets globally. Greece, the unpredictable oil rout and weak growth perspective in China repeatedly triggered waves of sell-offs during the last year. Here a closer look at the main characters or events that set the trends this year.

S&P 500 Yearly PerformanceSP500

Oil

The oil rout has started in the middle of last year, when it collapsed from the range $110/100 a barrel to levels close to the post Financial Crisis lows, $35/45 a barrel. Since the beginning of 2015, Oil has been very volatile, trading in a range between $35 and $65 a barrel. Its unpredictable trend affected financial markets on a global scale. The high-yield bond market is under strict observation after the low prices of oil have been pushing a large number of shale gas companies on the verge of bankruptcy. On December 10, Third Avenue Focused Credit Fund closed its $800m junk-bond portfolio due to the slump in bond prices. The energy sector has been dramatically hit by the rout, forcing layoffs, firm aggregation e.g. (Royal Dutch Shell and BG) and Capex reconsideration. Weaker demands from top-tier consumers as China and consistent OPEC plans to keep production high pushed prices down, weakening inflation expectations in developed countries and increasing risks of deflation. Emerging Markets heavily relying on oil exports have to cope with more than halved revenues from the primary source of inflow, currency depreciation and inflation. Brazil is reportedly in recession, Saudi Arabia disclosed a Balance Deficit of 15% of its GPD, envisaging austerity periods in public spending. Oil will still play a major role in 2016, when the ban on Iran oil exports will be lifted and new fresh oil will flood into the market.

WTI 5 Year PerformanceOilSource: Bloomberg

China

Being the second largest economy in the world, China has set the trend in many occasions this year. The Stock Market crash sparked fear and volatility all over the world. The Shanghai Composite, after a rapid ascent, it started to fall rapidly between June and August, losing almost 40% of its value. Weaker growth perspectives, decline in industrial production, and weaker demand for commodities, especially copper, dragged down global markets, spilling over other asset classes, especially Emerging Markets local currencies. In order to give China exporters a competitive edge People’s Bank of China devalued the renminbi several times during this year. In August, in the wake of the first devaluation, the Yuan reported the largest daily loss in over 20 years. Kazakhstan’s Central Bank, in order to cope with depreciating rival currencies, decided to shift to a free-floating rate. On August 15, the tenge tumbled 26%. These moves raised the risk of a potential currency war between August and September, which eventually fade away.

CNY/USD Yearly PerformanceYuan RenminbiSource: Bloomberg

In the first days of 2016 a dramatic sell-off in China that triggered the circuit breaker mechanism halting trading if losses greater than 7% materialize, produced a chain effect on the Financial System, resulting in the worst first week of trading in history. The S&P lost almost $1 trillion in market capitalization in the first week.

 Central Banks

The Fed and the ECB adopted divergent strategies in terms of Monetary Policy. Improved economic conditions and a more solid labor market in the US pushed the Federal Open Market Committee to unanimously raise interest rates up to 50 basis points for the first time in nine years. The December hike was broadly expected by all market makers, and paved the way for future hikes in the coming years. The ECB, in the opposite direction, eased the monetary policy in December, lowering the deposit rates at minus 30 basis point and prolonging the quantitative easing up to March 2017, with potential further extension. Draghi’s move disappointed market makers, who foresaw an increase in the monthly purchase of  securities, hammering down European Equities. Despite eased policies, inflation in both region is far from targets and the pressure on oil prices seems to further raise the risk of consistent low prices and deflation. Central Banks will still play a key role in the next year in their effort of improving economic conditions and reaching inflation target.

In the first days of the New Year, negative signals coming from the commodity market and China sparked uncertainty and fear over the stability of the financial system. Will the improved economic conditions in Europe and America be able to offset the downside risks coming from the Chinese transitioning economy?

By

Tancredi Viale, Master Student

On the verge of a collapse? – Weekly Market Update

On the verge of a collapse? – Weekly Market Update

Today, Greece was supposed to pay back $335m to IMF. Unfortunately, due to apparent impasses in the discussions between Greece and creditors, the repayment had to be postponed to the end of the month. Only Zambia in the 80s postponed an IMF payment. Tsipras said that it will be attached to other three tranches, totaling approximately €1.6bn. The stalemate is caused by disagreement on the reforms to be backed to the financing line. Alexis Tsipras cannot disrupt his political line to seal the deal. Syriza, his political party, is looking grudgingly at its leader, scared that he could accept unfavorable conditions to secure the loan, which would undermine the party’s coherence with electorate. Markets are nervous in this moment, with tornados taking place in the bond market. ECB’s President, Mario Draghi warned about volatility yet to come.

Today, another important data will be the job report in USA. Job Market is a very important metrics for the definition of Monetary policies in US. The data will be published in early afternoon.

By

Tancredi Viale