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Daily Commentary 23/01/15

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Draghi pulls out a European bazooka ECB President Draghi Thursday announced a larger-than-expected quantitative easing (QE) program, sending the euro down sharply and pushing Eurozone bond yields to record lows. I expect the program to continue to exert downward pressure on the euro, particularly if SYRIZA wins Sunday’s election in Greece and US rate expectations continue to rise, as seem likely.

The ECB’s move was surprisingly large in both its size (EUR 60bn a month, rather than EUR 50bn as was floated beforehand) and its duration (extending at least until Sep. 2016 or longer if inflation hadn’t returned to target by then). The program is to start in March, so the initial amount is EUR 1.14tn. On an annual basis it’s 7.5% of GDP, which is larger than the Fed’s 5.7% of GDP purchases, hence quite impressive. Moreover the open-ended commitment – to “do all that’s necessary” to get inflation back up, so to speak – was also more than the market had been expecting.

The effect of the announcement was muted somewhat because of the “non-mutualisation” of risk — the government bond purchases will be carried out by the national central banks, not the ECB. This is just a technicality for public relations purposes however, because unless they put capital controls into place, the risk is still spread throughout the Eurozone.

The ECB will allocate funds to each market according to that country’s contribution to the ECB’s capital, as we mentioned yesterday. That means the larger countries will see more bond buying. However, the ECB limited itself to buying 25% of any one issue and 33% of the total debt of any one country. (The latter limit will prevent it from buying any Greek bonds.) This means that as it reaches its limit in one country, it will have to go further into others to find bonds that it can buy regardless of those countries’ contributions to its capital. This is quite bullish for the peripheral bond markets, which otherwise might not see that much buying. Moreover, the ECB lowered the rate on the targeted long-term refinancing operations (TLTROs) to 5 bps, which means peripheral countries’ banks can borrow money for four years at 5 bps and use it to buy their governments’ bonds – nice work if you can get it!

We were anxious to find out what the vote was, specifically how many people opposed the decision. Oddly enough, the ECB didn’t vote on it! Draghi said that the majority was so wide that they didn’t need to vote. This is a nice way to hide the objections of any of the Northern participants and create a façade of unity over what was probably a contentious meeting. This is important to aid the psychological impact of the move.

Draghi said very little about the exchange rate, just that exchange rate movements were an inevitable spillover of monetary policy decisions taken for domestic reasons. “The exchange rate is not a policy target. It’s important for price stability, for growth, but it’s not a policy target. The movements in the exchange rate since three years were the outcome of diverging monetary policy cycles as well as divergent economic recovery paths between major jurisdictions. They were not intended, it was not an action geared to cause these exchange rate movements. They were the outcome.”

Conclusion: More EUR weakness to come While the ECB’s move did exceed expectations, it was nothing like the shock that the Bank of Japan delivered in October, with its wholly unanticipated move. Yet the range in EURUSD was almost the same as the range in USDJPY on that day (both around 3%). This suggests that the positioning in EUR is lighter than it was in JPY. If so, there is still more room for short EUR positions. The push may come from this weekend’s election in Greece (see below).

Saudi king dies; Brent prices jump Saudi Arabia’s King Abdullah has died. His successor is Prince Salman (79), Abdullah’s half-brother. Prince Muqrin, another half-brother and the youngest of his generation (at 69), is the new Crown Prince as expected. Brent prices rose on speculation that Saudi Arabia will cut back on production to push up the price in order to ensure that it has enough money for a smooth succession. However, the rhetoric in Davos has emphasized the likelihood of a recovery in oil prices over the next year, as is reflected in the oil futures curve (future oil prices are sharply higher than spot prices, which is the opposite of the usual situation in the oil market). I think the current Saudi policy has broad support in the Kingdom, as they have always taken a long-term view of the market, and so I do not expect them to change policy and do not expect today’s rally in Brent to last.

Today’s highlights: Friday is a PMI day. In China, the preliminary HSBC manufacturing PMI for January rose slightly to 49.8 from 49.6. While it remained in contractionary territory, the slight improvement (in contrast to the decline that the market was expected) suggests that China’s stimulus measures have helped to stabilize the country. That didn’t help to stabilize AUD and NZD, however. We also get the preliminary manufacturing and service-sector PMI data from several European countries and the Eurozone as a whole.

In the UK, retail sales for December are expected to fall, a turnaround from the previous month. The switch in interest rate votes from the two MPC members on the fears of low inflation, seem to have entrenched the negative sentiment towards the pound. Therefore, a weak retail sales figure could leave GBP vulnerable.

In the US, existing home sales for December are forecast to rise. The housing starts and building permits released earlier this week were consistent with an improving housing market. If the existing home sales are in line with a strong housing sector, this may be USD-supportive. Chicago Fed national activity index and Conference Board leading index, both for December are also coming out.

Canada’s CPI for December is expected to decelerate. Following Wednesday’s surprise rate cut, a drop in the inflation rate could ignite speculation about further rate cuts and could trigger a push higher in USD/CAD.

As for the speakers, Bank of England Governor Mark Carney speaks in Davos.

This weekend: Greece goes to the polls The most recent polls confirm that the SYRIZA coalition is likely to win the Greek election this weekend. It’s still questionable whether they will get enough votes to govern by themselves or whether they will need to form a coalition.

What are the policies of this party? Writing in the FT this week, party leader Alexis Tsipras said that his party offers “policies that will end austerity, enhance democracy and social cohesion and put the middle class back on its feet.” SYRIZA is not threatening to leave the Eurozone. He pledged that “A SYRIZA government will respect Greece’s obligation, as a eurozone member, to maintain a balanced budget, and will commit to quantitative targets.” His program has two main goals: ending austerity and renegotiate the debt.

How to maintain a balanced budget while ending austerity? Simple: increase revenues. “We will stand up to the tax-evading economic oligarchy,” he said. In fact it’s not just the rich who evade taxes; The Economist described tax evasion in Greece as “a national sport,” with over 40% of the population estimated to evade paying some EUR 30bn a year or more in taxes. That alone would be enough to put the government’s budget into surplus.

Tsipras called Greece’s “staggering” debt/GDP ratio of 177% “unsustainable” and called for renegotiation, which he correctly pointed out was exactly what Germany itself had to do with its war debt following WWII. This seems reasonable to me. There’s no way a country with 25% unemployment can pay down its debt without some growth. The costs of a long stagnation seem far more important than the loss associated with the debt restructuring, for creditors as well as for Greece.

There are many mainstream economists who recommend something similar in order to restart the Eurozone economy. The only problem is that few of them are German.

It’s clear that the negotiations will be tough and there will be many tense moments when the fate of the Eurozone seems to hang in the balance. But I expect the election of SYRIZA would be a good thing for Europe in that it would demonstrate that a change in policy can be accomplished without voting in the radical Right, whom I see as a much bigger threat to Europe. SYRIZA’s election and the successful renegotiation of its debt could prove a victory for European democracy, which is increasingly necessary for the Eurozone to continue.

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