Draghi did not expect THIS market reaction
The markets weren’t really expecting ECB president Mario Draghi to announce or say anything ‘shocking’ last week, but it’s now starting to look like Mr Draghi and Mr Carney, the President of the Bank of England (the Central Bank in Great Britain) have had several discussions in the past few days and weeks to make sure they’d spread the same message.
Mario Draghi caught its audience by surprise after telling his audience during the ECB’s annual forum ‘deflationary forces have been replaced by reflationary ones. As Morningstar correctly analyzed, this immediately resulted in the Euro gaining a lot of ground versus the US Dollar, reaching the highest level since June last year, as you can see on the next chart.
Still according to Morningstar, Draghi made it sound like the ECB had a plan to reduce the economic stimulus readily available for the ECB and this obviously caught investors by surprise as they were counting on the ECB lifeline with ‘free cash’ for an extended period of time. What makes Draghi’s comment really interesting is the fact Carney said pretty much the same thing in a different speech.
Despite the Brexit and the economic uncertainty connected to the UK potentially leaving the European Union, Carney was hinting on a BoE rate hike rather than an additional interest rate decrease. Not only did Carney hint at a rate hike, he also commented the ‘removal of monetary stimulus is becoming necessary’.
The comments from both presidents were a huge surprise as even though investors were expecting to see the stimulus measures being reduced, the tone of the announcements was pretty aggressive. Draghi’s written release tried to keep the total damage limited by referring to the Phillips Curve (which tries to correlate the wellbeing of an economy based on the inflation rate and the unemployment rate, as shown in the next chart:
Danske Bank argues the ECB thinks the ‘natural interest rate’ has increased, meaning the real interest rate gap has increased as well. In order to keep a certain monetary policy unchanged (the spread between the real interest rate and the actual interest rates of the central bank), the central bank will need to update its interest rate policy in order to keep the policy unchanged (increasing the intended interest rates reduces the gap with the real interest rate).
Source: Danske Bank
Danske correctly notes the ECB is very likely too optimistic (something we also have already pointed out in our previous columns). Just like in the USA, the ‘real’ inflation rate simply isn’t there; as the majority of the YoY inflation was caused by higher energy prices. This wasn’t a surprise at all as the oil and gas prices were trading at multi-year lows (and even decade lows) so any increase in the energy prices would have had an impact on the ‘headline’ inflation rate. But the ‘real’ inflation rate is very likely still way below the eyed 2% mark.
Whilst the central banks are pretending all is well with the world economy and are hinting at future interest rate hikes, things aren’t as great as they want you to believe. The so-called ‘move away from ultra-easy policy’ might come way too early. Unless, of course, we’ll move from ‘ultra-easy’ to just ‘easy’…