"You don’t understand me"
- The Raconteurs
Over recent weeks it has become more apparent that financial markets have extended the focal point of their macro analysis beyond the near term uncertainties of the pandemic towards the likely proximity and strength of the recovery – assisted in no small part by the US fiscal stimulus (formally confirmed this week) of a further ~10% GDP. This focus on the recovery has put further pressure on policymakers to describe and quantify the terms defining their preferred monetary policy guidance narratives more clearly. This week, that focus fell on the European Central Bank (ECB) President and the ‘favourable financing conditions’.
The ECB, as widely expected, pledged PEPP purchases over the next quarter would be conducted at a “significantly higher pace than during the first months of the year”, while maintaining commitments to flexibility across time, asset classes and countries – at least through to the end of March 2022 – and that the PEPP envelope (EUR 1.85 trillion) could be increased or not fully utilised, dependent on the ECB’s ability to maintain “favourable financing conditions”. Effectively pushing back or leaning into the recent rise in yields.
Then, at the start of the Q&A the ECB President pre-empted a question on favourable financing conditions and attempted to provide the following clarity:
“I use the word ‘holistic’ and I use the word ‘multifaceted’... What we mean by holistic is that we cover the whole chain of transmission...from the upstream stage...to the downstream aspect...That clearly includes a multiplicity of rates...upstream is clearly an important component but it is not the component of our assessment of the financing conditions, which is why I use the word holistic...We don't operate mechanically...It's also important to be multifaceted because there are some downstream components that are not necessarily going to be influenced by upstream movement...So we use all that and with a bit of good work, good analysis based on projections and this joint assessment, our monetary policy will contribute to taking the economies across the bridge of the pandemic.”
Clear? Apart from the mixed metaphors of crossing bridges either up or downstream (while seemingly losing an oar somewhere in the middle), the President failed to offer a concise narrative surrounding the ‘favourable financing conditions’. However, she did reference a speech by the ECB Chief Economist that covers the subject and does help clarify the intent and meaning of the phrase.
Published on the 25th February – the same day that a weak 7-year US Treasury auction saw 10y yields rise 24bps in one day (and subsequently accelerating the monetary policy, inflation and even fiscal policy normalisation debate that we discussed last week) – the EBC Chief Economic set out some “considerations for thinking about favourable financing conditions as the compass guiding monetary policy.” From my perspective, this gave greater clarity around the ECB’s current stance.
The Chief Economist outlined ‘favourable financing conditions’ as a compass or a methodology through which monetary policy, and specifically the transmission of monetary policy, should be viewed. The important context here (which I feel was lacking in the President’s explanations to date) is the idiosyncratic issue that in the eurozone, banks are the main providers of credit to households and firms. Thus, when the ECB refer to ‘favourable financing conditions’ being a holistic and multifaceted approach, they are referring to the fact that a spectrum of indicators covering the entire transmission chain should be monitored – not just the risk free or sovereign yield curve (as is the predominant driver of funding cost and thus monetary transmission in the US) – but also the supply and cost of credit through bank and financial intermediaries. The ‘multifaceted’ part refers to the fact that each indicator is monitored to provide a valuable signal on each specific segment of the transmission process.
So ‘favourable financing conditions’ is a compass or mirror to guide and monitor monetary transmission, but the ECB also sees it as an integral part of their monetary toolbox as part of its forward guidance pledge, aiming to reduce uncertainty in funding markets (from banks to households to governments by a commitment to maintaining accommodation/access) and thus underpin confidence in the recovery. In essence ‘favourable financing conditions’ is a framework to look at monetary transmission, a basis under which to shape or alter policy and a forward-looking commitment to maintain accommodation.
As the President’s attempt to define ‘favourable financing conditions’ at the press conference attests, the current narrative is intentionally broad and vague. Indeed, one commentator (generously?) described it as ‘creatively ambiguous’. From my perspective, the favourable financing conditions narrative is an alternative way to foster easier monetary conditions in the eurozone when there is no appetite in the ECB Governing Council for either lower (more negative) rates or an increase in the PEPP envelope when there is still so much left in it. In that regard, it is an interesting addition to the toolbox. However, it is of limited use at best, if it cannot be effectively communicated.
It also likely gives the ECB the flexibility (rationale?) to maintain or even increase accommodation, whether market-based barometers imply tightening or not, and thus I think it should be viewed as an intentional further dovish divergence of monetary policy relative to its peers.
So what does this mean for markets?
If we incorporate favourable financing conditions as part of the ECB toolbox and the core points of yesterday’s ECB meeting, we continue to see the ECB stance as more dovish than the Fed. While the ECB President protested that the ‘significant’ increase in PEPP purchases over the coming quarter did not amount to yield curve control, it is a clear push back against market pricing and the direct link between US reflation expectations and the financial conditions in the eurozone.
Further, the updated staff projections from the ECB Governing Council highlight a “temporary and technical” rise in inflation over this year and next, but ultimately an inflation projection at the policy relevant horizon (end-2023) of just 1.4%, which the ECB President conceded remains far below the pre-pandemic path and far below the ECB mandated target of close to but below 2.0%. This further underlines the need for policy accommodation to stimulate domestic demand.
Over recent weeks, we have discussed our view that the recovery from the global pandemic is unlikely to take the form of the uniform global recovery from the global financial crisis, but more likely will see clear divergences across the globe. In our framework, the US, with its more dynamic economy, fewer pre-existing conditions, higher potential growth rate and an unrivalled and unprecedented fiscal stimulus will see growth and yield differentials widen in favour of the US (ECB forecast 4.0% in 2021 and 4.1% in 2022 – we shall see where the Fed raise their growth forecasts to next week). Notably, we do not see rising yields unravelling the recovery (at least not in the US) or damaging the near-term growth impetus; rather, we see it supporting it.
From our perspective, this continues to favour the USD and should weigh on the EUR. Perhaps most ironically of all, against the current backdrop, it is likely that a lower EUR would have the most favourable impact on the eurozone's financial conditions of all…upstream and downstream.
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