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Ambrose Evans-Pritchard: Deflation alert in Europe as markets lose faith in 'powerless' ECB
By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, June 6, 2019
Futures markets in the eurozone are flashing the most serious deflation warning since the creation of the single currency, dismissing stimulus measures and dovish rhetoric from the European Central Bank as thin gruel in the face of mounting recession risks.
A closely watched gauge of inflation expectations -- 5-year/5-year forward swap contracts -- crashed to a record low of 1.23 percent today despite pledges from the ECB that it would hold interest rates at deeply negative levels far into 2020, and despite hints of more quantitative easing to head off a Japanese-style trap.
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ECB president Mario Draghi said the bank is "determined to act in case of adverse contingencies" and will use all instruments in the toolbox -- code for emergency stimulus if the slump in world trade deepens and a global economic downturn takes root.
Analysts say the policy shift comes too late, and is too tentative, to assuage worried investors. Pricing in futures contracts shows that markets do not believe the ECB will come close to meeting its 2pc inflation target over the next decade. This is an emphatic verdict of no confidence in the monetary management of the institution, but it also has dangerous macroeconomic consequences.
Peter Schaffrik at RBC said markets increasingly fear that the ECB has "fallen behind the curve” as prices tumble across the commodity nexus and returns on German government bonds hit historic lows. This is allowing a corrosive dynamic to take hold.
He said corporate bond markets are caught in a double squeeze. Risks spreads are rising and real borrowing costs are also jumping as implicit inflation spiral downwards. The combined effect has already caused a 45-basis point rise in credit costs for low-to-mid grade companies since early May.
It is a hazardous feedback loop: the more inflation expectations fall, the more real yields rise. "The central bank loses its ability to counteract the weakness," Mr Schaffrik said.
The ECB's package of measures includes a fresh round of cheap loans to banks (TLTROs) at rates as low as minus 0.3 percent, providing badly needed liquidity to prop up broken banking systems in Italy and other parts of the eurozone. Even so, lenders in the periphery of the eurozone will in effect be rationed to about E30 billion.
Analysts said the latest moves are too little to shore up the eurozone defences against a global slowdown. "If the economy continues to stagnate, the ECB will be forced to intervene. Turning the QE taps back on by the end of the year is an increasingly probable scenario," said Nancy Curtin of Close Brothers.
A short-lived rally on European stock markets faded quickly as investors sensed that Mr Draghi was trying to send a dovish message with cheap talk rather than meaningful action. He is almost certainly constrained from acting by northern European hawks on the governing council.
The days are long gone when the ECB maestro can restore animal spirits with a catchy phrase. The famous bazooka has become a popgun.
Mr Draghi said the likelihood of deflation in the eurozone was "zero" but also revealed that some council members had for the first time spoken of fresh asset purchases at their policy meeting this week. This is a remarkable development coming so soon after the ECB shut down the programme in December declaring mission accomplished.
Ashoka Mody, a former bailout chief in Europe for the International Monetary Fund, argued that the ECB has run out of usable policy ammunition. "There is nothing that the ECB can do. It is completely powerless. It has entered a zone of 'involution' and is scrounging about trying to create a sense of action, but none of this has any effect," he said.
Only fiscal stimulus a l'outrance now has the potency to fight an economic downturn, but this is rendered almost impossible by the eurozone's Stability Pact and Fiscal Compact, and the lack of a shared budget with joint debt issuance.
Mody, now at Princeton University, said inflation expectations had become irreversibly "de-anchored." This is playing havoc with real interest rates and debt sustainability. "The consequences are horrible, not just for Italy but also for France," he said.
Chronic "lowflation" in the South is further fragmenting the eurozone. Italy's real borrowing costs are rising and have reached 2 percent even as the economy slides back into recession. This level amounts to slow death for a high-debt country with no growth. The debt-to-GDP ratio is spiraling upwards.
By contrast, Germany's real rate is minus 1.7 percent, measured by 10-year debt. This divergence is politically and economically unsustainable and at some point it will snap. "History moves at the speed of a glacier, until it turns into a torrent," Mody said.
Mody said there was "not a shred of evidence" that the TLTRO's loans to banks would make any difference at this stage and warned that more QE would further concentrate the bank/sovereign "doom loop" without doing much to boost the economy: "QE in the eurozone has been a flop."
The original sin was to tighten policy prematurely after the Lehman crisis before the recovery was self-sustaining. The ECB waited far too long to launch QE during the Trichet era, allowing the deflationary cancer to become lodged in the tissue. When it did belatedly act, the disease had already begun to metastasize. Huge doses of QE -- pushing the balance sheet to over 40 percent of GDP -- were still not enough to restore health.
"It has been a pattern of denial, delays, and half-measures. The ECB has the trappings of a central bank but it is not a normal central bank at all. It is a political animal," Mody added.
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