More pain expected before ECB steps in
0The global financial crisis will likely lead to synchronized quantitative easing (QE) in Japan, the US, the UK, Switzerland and Euroland and recent macro data suggest that this may be relatively soon.
– The very weak May PMI report in the UK (with the new orders index dropping by seven points from 49 to 42, the largest drop in eight years) looks to have increased the probability of BoE QE4;
– The disappointing increase in US payrolls in April and May has led economists to expect further action by the Fed during the June 19th/20th FOMC meeting, potentially involving an increase in the Fed balance sheet;
– The Bank of Japan decided at the end of April to increase the total size of the Asset Purchase Programme by ¥5tn, or an additional 1% of GDP. Economists believe that the BoJ will be forced into even bolder steps in the second half of 2012.
The critical question, however, is what will get the ECB to respond to the crisis in Euroland, given the degree of the response required (a €2tn LTRO – or a ECB deposit guarantee, with Euroland deposits outstanding at €10tn) and the fact that the ESM and the fiscal compact is still only ratified by four and three countries respectively (thus we are far removed from the political union that normally precedes a fiscal union).
We may expect that the catalyst will be one of four events:
1) Large-scale and very visible deposit flight (although the deposit data we are seeing is deteriorating, nothing is yet on the scale of Northern Rock style queues);
2) Escalating funding stress in the government or bank funding markets. This would either mean Spanish and Italian two-year yields going back to last November levels (6.1% and 7.6%, compared to 4.9% and 4.4% now – in a way that Spain would effectively be unable to fund itself in the market even at the short end), or it would mean stress indicators of bank funding rising strongly from current levels (yet, yields on Tier 1 debt and Euribor/Eonia have hardly moved so far);
3) A Greek exit, at which point it becomes much more acceptable politically to accelerate federalisation via the ECB’s SMP and ESM or;
4) Non-financial indicators falling to levels consistent with minus 2% GDP (i.e., PMI falling below 40).
None of these conditions are in place yet – but any one of these could be in place within a few weeks.
We believe that the ECB under Mr Draghi is more dovish and more pre-emptive in style and approach than it was under Mr Trichet, but we fear that at least one of the catalysts above are needed.
Ultimately, we believe that the degree of crisis required to lead to an expansion of central bank balance sheets lessens over time: QE1 required a 34% fall in equities, QE2 a 14% fall. So far, the S&P 500 is down 10% from its peak.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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