It’s all about the tie

 

A couple of years ago, investors would have paid a fortune to possess a crystal ball and use it to forecast ECB’s decisions.

Today, all they need is Mario Draghi’s tie.

In fact, some people seem to play a weird game – by the name of “tie guesses” – that consists in guessing the colour of Draghi’s tie and treating it as an economic indicator.

Nobody knows whether the governor actually knows about this elaborate guessing game (probably he does), but surprisingly it seems to work. Or at least it worked on March 10th when he announced the new measures to boost the European economy and financial system. In that occasion, Draghi wore the same tie he did in July 2012 when he made the famous “whatever it takes” speech, announcing the ECB’s dedication to preserve the monetary union and to save the euro.

Four years ago, the European Central Bank’s stimulus exceeded investors’ expectations. So, it did two weeks ago during the press conference held after the meeting of the Governing Council.

After a careful economic and monetary analysis, the Governing Council has decided on a set of measures – defined “comprehensive package” – in the pursuit of its price stability objective.

First, the ECB decided to lower the interest rate on the main refinancing operations of the Eurosystem by 5 basis points to 0.00% and the rate on the marginal lending facility by 5 basis points to 0.25%. The rate on the deposit facility was lowered by 10 basis points to -0.40%.

Second, it decided to expand the monthly purchases under the asset purchase programme from €60 billion at present to €80 billion – intended to run until the end of March 2017.

Third, it decided to include investment-grade euro-denominated bonds issued by non-bank corporations established in the euro area in the list of assets that are eligible for regular purchases under a new corporate sector purchase programme.

Fourth, it decided to launch a new series of four targeted longer-term refinancing operations (TLTRO II), starting in June 2016, each with a maturity of four years – with the aim of strengthening the transmission of monetary policy and further incentivising bank lending to the real economy.

Quite comprehensive package I would say, but what did market think about these measures?

As Draghi began to speak, the STOXX 600 surged as much as 2.5% and the euro dropped as much as 1.6%, but suddenly things started to take a curious turn. Indeed, at some point during the press conference, the euro unexpectedly surged 1.2% and the STOXX 600 closed the trading day over 1.6% lower.

What happened?

The solution is in the rest of Draghi’s speech. Indeed, he revealed that the Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time and also that the ECB can cut interest rates further, but isn’t likely to, at least for the moment.

In his own words:

“Let me say that rates will stay low, very low, for a long period of time, and well past the horizon of our purchases”, Draghi commented. “From today’s perspective, and taking into account the support of our measures to growth and inflation, we don’t anticipate that it will be necessary to reduce rates further. Of course, new facts can change the situation and the outlook”.

In a nutshell, markets reacted in that way, following the comments on negative rates.

A question arises at this point. Are markets really expecting lower interest rates in the future? It’s not easy to say whether a further drop in interest rates will boost the European economy. However, the only evident thing is that – apart from the Federal Reserve – a large part of the major Central Banks of the world is still lowering rates.

Few examples are offered by the Norwegian Central Bank that cut the interest rates to 0.500% from 0.750% only last Thursday; the Indonesian Central Bank from 7.000% to 6.750% on the same day; the Bank of Japan from 0.100 % to 0.000 % at the beginning of February; and the Swedish Central Bank from -0.350 % to -0.500 % in February as well.

This is the evidence that the world is (and it will be for a long time) a low-rate environment. However, while money becomes cheaper, prices still remain low. According to Eurostat’s flash estimate, euro area annual HICP inflation was -0.2% in February 2016, compared with 0.3% in January.

Why? Probably, the transmission mechanism of monetary policy isn’t working properly. Or we could have been missing something more important here. Some people think that the ECB is wrong and that low inflation is a new paradigm. Others believe that it’s all a matter of time and that inflation will raise to the 2% target in the long-run.

Nobody seems to have the correct answer. In the mean time, all we can do is to guess the colour of Draghi’s tie.

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