Why You Need to Care More About the ECB Than You Probably Do.

Why You Need to Care More About the ECB Than You Probably Do.

I realize not everyone will have read this by the time the ECB makes its policy announcement (in 45 minutes) or when Draghi holds his press conference (in 90 minutes), but I want to include this analysis because simply put, Europe is really important right now.

Europe is by far the weakest major developed economy in the world, and it’s teetering on the brink of a triple-dip recession, if not worse.  And, seeing as a “global recovery” is one of my 4 pillars of the stock market rally, if the EU slips back into recession, that will be a headwind globally.

So, understanding what’s happening with the EU economy and what the ECB is doing is very important.  It is equally important as understanding what Fed policy was during the past three years here in the U.S. – because like the US economy with the Fed back then, the EU economy is now totally dependent on the ECB to provide stimulus.  This is all about the ECB.

Before going into what’s expected from the ECB today and the implications on policy, it’s important to make sure we correctly understand the setup …

First, the major threat to the EU is deflation.  That threat has resulted in European bonds surging to record levels, and a rise in the expectation that the ECB will eventually do QE—just as the BOE and Fed did when faced with a deflation threat in ‘11/’12.

Second, think of EU (especially German) interest rates as an inverse indicator of deflation.  So, the lower the yields go, the higher the market expectation the EU will actually find itself in deflation (and German yields are just off record lows).

Third, unlike the Fed when it did QE, the ECB’s goal isn’t to lower interest rates.  Interest rates in the EU are already too low.  For the ECB to start winning this economic fight, interest rates need to start rising. That will reflect increasing inflation expectations and an uptick in the demand for money (which means increased economic activity).

Fourth, if the ECB does not ease policy materially this morning (i.e. is hawkish), you will see EU interest rates go down, as the expectation of a deflationary crisis in the EU grows and investors rush for cover.  Conversely, if the EU shocks the world and actually announces QE, rates likely won’t decline by all that much in Europe, as that will ultimately be inflationary.  Those two reactions are the opposite of what should  happen normally, but again this is about deflation expectations, not about the level of interest rates.

With that in mind, let’s turn to ECB expectations:

Consensus:  No changes to policy. Draghi talks “dovish,” threatens QE, but basically plans to wait and see if the plans announced in June (TLTROs/ABS purchases) can help jumpstart the economy.  Market Reaction:  European bonds and the euro will rally (which is bad) and European stocks will likely fall.

“Slightly Dovish”:  Draghi announces some tweaks to the existing TLTRO program by reducing the fee to use it, increasing the size, releases more specific plans on the Asset Backed Lending program or makes further small cuts to interest rates.  Market Reaction:  The market wants QE; this won’t satisfy it.  Look for a mild decline in European bond yields and EU stocks.

“The Total Surprise”:  ECB announces QE. Market Reaction:  This would be a total shock – but if so, European (and U.S.) stocks would scream higher. EU bond yields would decline but only modestly – and may even rally. Treasury reaction would be tough to gauge, but I think we’d see a Treasury sell-off after an initial spike higher.

I know we don’t normally think of Europe as a key influence on stock prices – but it’s a different world nowadays. The bottom line is what’s happening with the EU economy (and specifically its influence on Treasuries) is critical to monitor – and we’ll continue to stay on top of it.