The European Central Bank (ECB) delivered today on the expected dose of additional stimulus for the Eurozone; but before I get into the ECB’s moves and their implications, let me first focus on the Federal Reserve (Fed).
I believe that for the health of the global economy the Fed should get off the tightening path now. If that results in U.S. inflation rising above the Fed’s 2% target in the short term, it is, in my view, an acceptable risk in the current environment.
Having said that, recent price action in the foreign exchange (FX) market is providing Fed policymakers another window of opportunity that may potentially allow them to ignore the secular issues facing the world and instead pursue a Phillips curve-driven cyclical tightening agenda.1
If carried to an extreme, that could lead to a catastrophic slowdown in global growth a year or two down the road, which may cause the end of the current business cycle and bull market. It may sound like hyperbole today, but it is a substantial enough risk that investors should take notice.
Removing Constraints on Fed Tightening
What am I talking about?
As the Fed started down the path of policy tightening in the middle of 2014, one of the biggest constraints on the Fed has been the tightening of financial conditions and the deflationary effects of a strong dollar. The dollar has risen approximately 27% against most major currencies since mid-2014, and the ensuing economic slowdown has thrown a monkey wrench into Fed policymaking to the extent that some policymakers, such as Lael Brainard, were starting to get traction with a more dovish perspective with the full Federal Open Market Committee.
Unfortunately, of late, FX volatility is going down and the dollar is not rising much. As a result, one of the market constraints keeping the Fed from going gung ho into tightening mode is actually being removed. If it persists for a few months with strong U.S. economic data, I would assume that the probability of the Fed raising interest rates a few times in 2016 goes up and goes up meaningfully. The price action today in the Treasury curve and the euro vs. the dollar after the ECB announcement indicates that the market is starting to price-in that risk.
Implications of ECB Easing
That brings us to the ECB.
The ECB’s moves today were substantially dovish on all counts:
- A 10 basis points cut in deposit rates,
- A €20 billion increase in the amount of monthly quantitative easing (QE), and
- Investment-grade, non-financial corporate bonds are now eligible to be purchased as part of the QE program.
At the margin, the ECB’s easing moves are positive for risky assets in the near term. With the dollar stable, emerging markets showing signs of recovery, oil stabilizing, and China going down the path of monetary and fiscal support, the near-term outlook for risky assets is quite good.
However, the longer term outlook is still dependent on what the Fed does. In that context, significantly lower dollar volatility releases a financial condition constraint on the Fed and that may lead it down the path of more aggressive tightening than the markets may be anticipating. In that case, the current rally may end up being short lived.
I sincerely hope I am wrong and that instead of worrying too much I should just enjoy the current rally.
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1 The Phillips curve represents the historical inverse relationship between unemployment rates and inflation rates within an economy, i.e., when unemployment is high wages increase slowly, and when unemployment is low wages increase rapidly.↩
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