Why ECB’s de­ci­sion to re­duce QE is a cause for con­cern

The National - News - - BUSINESS IN DEPTH - MO­HAMED EL ERIAN Bloomberg

If gov­ern­ments, com­pa­nies and mar­kets needed any fur­ther re­minders that their op­er­at­ing environment is chang­ing, they got it last week.

De­spite weak­en­ing eco­nomic mo­men­tum and volatile fi­nan­cial mar­kets, a sec­ond sys­tem­i­cally im­por­tant cen­tral bank, the Euro­pean Cen­tral Bank, re­it­er­ated its in­ten­tion to stop us­ing large liq­uid­ity in­jec­tions to sup­port eco­nomic ac­tiv­ity and as­set prices.

The change in this “global fac­tor” is trans­lat­ing into a volatil­ity “regime change” in mar­kets, re­quires an evo­lu­tion in in­vest­ment strate­gies and calls for com­pen­sat­ing pro-growth pol­icy mea­sures on the part of many in­di­vid­ual coun­tries.

The ECB’s an­nounce­ment last week that its gov­ern­ing coun­cil still in­tends to stop large-scale as­set pur­chases, known as quan­ti­ta­tive eas­ing or QE, at the end of the year oc­curred in the con­text of what cen­tral bankers ac­knowl­edge is an in­creas­ing list of threats to their economies.

Af­ter the cen­tral bank’s pol­icy meeting, ECB pres­i­dent Mario Draghi said the risks in­clude an uncertain trade regime, pres­sures in emerg­ing mar­kets, pol­i­tics and the bud­getary con­fronta­tion be­tween Italy and the Euro­pean Union.

And by stat­ing that the “ECB man­date does not in­volve fi­nanc­ing govern­ment’s deficit”, Mr Draghi em­pha­sised the im­plicit mes­sage that nei­ther gov­ern­ments nor mar­kets can con­tinue to rely on reg­u­lar, large and pre­dictable liq­uid­ity in­jec­tions to off­set their own prob­lems.

The ECB’s sig­nals re­in­force those that the Fed­eral Re­serve has been send­ing for a while now. De­spite weak­ness in hous­ing, a his­tor­i­cal in­di­ca­tor of cycli­cal trends for the US econ­omy, and notwith­stand­ing com­plaints by US Pres­i­dent Don­ald Trump, top Fed of­fi­cials con­tinue to leave no doubt of their in­ten­tion to fur­ther raise in­ter­est rates while re­duc­ing the bank’s bal­ance sheet. More­over, this Fed team, un­like its pre­de­ces­sors, is less in­clined to re­sort to soothing words to calm unset­tled mar­kets.

The in­crease in mar­ket in­sta­bil­ity should come as no sur­prise. It was clear from early in this (now-end­ing grad­u­ally) ex­cep­tional mone­tary pol­icy phase that the “unconventional poli­cies” of cen­tral banks were aimed at re­press­ing volatil­ity as a means of pro­mot­ing eco­nomic ac­tiv­ity. Cen­tral banks have also been con­sis­tent and clear about their in­ten­tions to exit this phase as eco­nomic con­di­tions al­low.

The re­sult­ing jour­ney away from the pro­longed in­tro­duc­tion of unconventional poli­cies in­her­ently in­volves more fi­nan­cial and eco­nomic volatil­ity.

This is espe­cially true given how much mar­ket par­tic­i­pants have down­played liq­uid­ity risk in cer­tain seg­ments and how many gov­ern­ments have been slow in in in­tro­duc­ing pro-growth struc­tural re­forms.

What the des­ti­na­tion will look like re­mains an open ques­tion, how­ever. The out­come essen­tially de­pends on the or­der­li­ness and com­pre­hen­sive­ness of the hand-off to bet­ter eco­nomic and cor­po­rate fun­da­men­tals, as well as the re­set of mar­ket tech­ni­cals.

As I have ar­gued, this tran­si­tion is made more uncertain by the diver­gent eco­nomic per­for­mances within the ad­vanced world, as well un­cer­tainty about trade pol­icy.

It will also be tested by two el­e­ments: pock­ets of ex­ces­sive risk-tak­ing that emerged dur­ing the pre­vi­ous pe­riod of am­ple liq­uid­ity (from the ex­ces­sive reach for yields, in­clud­ing through off-bench­mark in­vestor ex­po­sures, to the spread of prod­ucts that im­plic­itly prom­ise im­me­di­ate liq­uid­ity at rea­son­able bid-off spreads); and the ex­tent to which cer­tain gov­ern­ments and cor­po­rates used the pe­riod of un­usu­ally low in­ter­est rates to pile on too much debt, cre­at­ing ex­ces­sive cur­rency mis­matches.

The mes­sage to gov­ern­ments, cor­po­rates and mar­ket par­tic­i­pants is clear: cen­tral banks are com­pletely se­ri­ous about get­ting out of the busi­ness of sup­press­ing volatil­ity and the process could be ap­proach­ing crit­i­cal mass. Much like what hap­pens to you when you take off those fancy noise-can­cel­la­tion head­phones in mid-flight on a plane and no­tice all sorts of noises around the cabin, mar­kets and economies are be­com­ing more sen­si­tive as QE and guid­ance on low rates de­cay.

Eco­nomic ac­tors and mar­ket par­tic­i­pants need to pre­pare for greater en­vi­ron­men­tal in­sta­bil­ity as mone­tary pol­icy tran­si­tions away from un­usual and ex­per­i­men­tal mea­sures to his­tor­i­cally more recog­nis­able ones. This change has the po­ten­tial to place both the global econ­omy and mar­kets on a more solid fun­da­men­tally based foun­da­tion over the longer term. But it also re­quires timely adap­ta­tions in both or the pos­si­bil­ity of the bet­ter could give way to the agony of the worse.

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