Nearly two and a half years after European Central Bank (ECB) President Mario Draghi gave his famous “whatever it takes” speech, markets are still waiting for him to “show us the money”.
It has also been six months since the initial talk of €1 trillion in ECB asset purchases to ward off deflation risks, but markets have yet to see any of this money. In fact, after peaking at over €3 trillion in the summer of 2012, the ECB balance sheet is now below €2 trillion. The balance sheet has shrunk by €100 billion in the last six months, and while ECB committees and staff are hard at work on timely preparation of further measures, President Draghi has also introduced the phrase “if needed”. The actions of the ECB have not kept up with the rhetoric — the ECB has not shown us the money. It does, however, remain “ready to act”, “if needed”.
Figure 1: ECB balance sheet
While talk is cheap, the rhetoric about additional unconventional measures from the ECB has managed to move the US-dollar-per-euro exchange rate to US$1.23/€. That rate is down from its 2014 high of US$1.39/€ in March. However, today’s exchange rate of US$1.23/€ is not too different from the exchange rate of US$1.27/€ on December 4, 2008—at the height of the Lehman Brothers crisis.
Figure 2: US dollar vs. euro
The Bank of Japan (BoJ) has undertaken an aggressive quantitative easing (QE) program and has arguably taken the lead in the race to devalue its currency. The US Federal Reserve’s (Fed) three episodes of QE expanded its balance sheet to just under US$4.5 trillion. Though it has just ended its large-scale asset purchase program, the Fed will continue to reinvest in MBS in order to maintain the size of its balance sheet. The ECB’s plan to purchase up to €1 trillion in covered bonds and ABS has its critics, most of whom think the market is too small to support and sustain such purchases. Further, purchases of sovereign debt remain controversial, although Mr. Draghi has said “we don’t need unanimity” to undertake sovereign QE. For now, the can has been once again kicked down the road into 2015. Markets will have to wait to be shown the money.
US economic data continues to be supportive, with the November non-farm payrolls report showing an addition of 321,000 jobs and the unemployment rate steady at 5.8%.Average hourly earnings rose a healthy 0.4% m.o.m. versus October, indicating a continued reduction in labor market slack. Fed speakers this week indicated that they are on track for a normalization of interest rate policy and for rate hikes in 2015. The US economy continues to make progress in its recovery. Growth indicators are trending higher, and the employment outlook continues to improve with strong jobs growth and a positive upward trend in wages.
Figure 3: Non-Farm Payrolls Net Monthly Change 1/1/2008 - Present
It is, in our view, appropriate for the Fed remove the unconventional policy accommodation and to move toward a normalization of interest rate policy. The growth in the US comes in spite of concerns about a global growth slowdown and continued weakness in Europe. Additionally, the sharp drop in energy prices has the potential to be a boon for US consumers. We think that the Fed’s transition to a more normalized interest rate policy will lead to a bias for higher US rates, higher interest rate volatility and wider spreads for risk assets in fixed income. As we have seen from previous taper tantrums, the sectors furthest away from the government-guaranteed sector will experience the greatest volatility.