Dolan: The ECB Is Out Of Ammo...Now What?

The ECB fires the last round

In my Global Market Outlook for 2016, I suggested that major central banks (excluding the US Fed) would continue to grease the global economy with additional easing measures. So far, the Bank of Japan (BOJ) cut rates into negative territory at the end of January. In February, the Peoples Bank of China (PBOC) cut rates again and also lowered the reserve ratio for banks to further spur lending. A number of smaller central banks have also undertaken additional easing, such as Sweden in mid-Feb. and New Zealand today.

On Thursday, the big news came from the European Central Bank (ECB), which cut rates further into negative territory (o/n rates from -0.3 to -0.4%) and increased the size and scope of its asset purchase program (quantitative easing or QE). The ECB moves were mostly as expected (though the expansion of assets eligible for purchase might be considered an added boost). And the market reaction perfectly reflected a buy the rumor/sell the fact outcome.

I cited my 2016 Outlook at the beginning of this note because much of my expectation for the year was predicated on central banks riding to the rescue, stopping the Jan/Feb global market meltdown and sparking a rebound. However, I thought the process would be a little more drawn out, perhaps playing out over the first half of the year, rather than happening in just 2.5 months.

US and China—Last Two Standing

Now that the ECB has likely fired its last volley for the year, I’m looking at the Fed and PBOC as the only two real actors left on stage. To be sure, the ECB and BOJ can continue to cut rates even further into negative territory, but I don’t think there is much more traction to be had via rates. On the QE side, they’re both basically up against limits of what assets they can actually buy, so I would not expect much further relief there. (The one bright spot for those two economies would be if Japan drops plans to raise its sales tax later this year, which appears to be happening. But rather than boosting Japanese prospects, it only removes a potential drag. Still, overall positive for Japan)

Which brings us back to the Fed and the PBOC/China. For China I expect additional stimulus measures throughout the year as circumstances warrant. The Chinese appear to have dusted off the playbook of easing credit and boosting infrastructure investing as a means of supporting the domestic economy. On the whole, that’s a positive for the global economy in general (risk-positive), and for commodities and emerging markets in particular. It remains to be seen, though, how successful those Chinese efforts will be; keep a sharp eye on incoming Chinese data, the most recent of which suggest a little more gloom before any dawn.

The Fed Pendulum Keeps Swinging

For the Fed, we are about ¾ of the way through the first round-trip cycle of Fed rate hike expectations: the year began with high expectations of another Fed hike in March; expectations then fell to zero; and have lately begun to rebound for a hike in June (see chart). I think the Fed rate hike expectation pendulum will continue to swing throughout the year, and that formed the basis of my 2016 outlook that stocks would continue to swing as well.

Market Expectations of a Fed Rate Hike at June Meeting

Source: Bloomberg; DriveWealth

Fed rate hike expectations will continue to be heavily US data dependent, and recent indications support a Fed move in June. However, between global headwinds and anemic wage growth, the risks are still biased to US growth faltering rather than accelerating, meaning the Fed pendulum is most likely to swing back toward reduced rate hike expectations. Only truly stellar US data coupled with at least stable global momentum would cause rate hike expectations to increase beyond one more hike this year.

I don’t think there is any basis to the view that the Fed’s rate target can’t continue to diverge from other major central banks. They have statutory obligations to uphold and the US is a more closed economy than others, meaning the Fed must focus on US conditions. Of course, global developments will have an impact on Fed decision making insofar as they will affect the US outlook, but there’s no rule that says US rates can’t continue to diverge.

On that note, don’t forget the US dollar. As the Fed expectations pendulum continues to swing, so too will the US dollar fluctuate against other majors. To the extent Fed rate hike expectations increase, the buck should do better against most. But there’s also a dollar-negative asymmetry involved if the global picture deteriorates: the US dollar has more downside risk if US rate hike expectations soften than it does upside potential if US rate hike expectations increase. That’s mainly due to market positioning in favor of the US dollar and against other major currencies overall.

Near-Term Outlook

On balance, then, I’m staying with my view that developed global stocks remain the only viable prospect for investors seeking returns in 2016. And also that global markets will continue to see-saw as a result of the stuttering global outlook, suggesting a more active approach to buying dips/selling rallies.

We have just gone through the first cycle—stocks down/buy dips; stocks recover/sell rebound. I think the current recovery is in the process of stalling and I would now be looking to take advantage of potential pullbacks to re-establish a core long position in global stocks. The post-ECB reaction suggests a market failure and potential rejection from key levels (In the MSCI World Index MXWO, possible failure above the daily cloud, above the Weekly Kijun line, and a stall at the 61.8% retracement of the decline since the last ECB meeting.) (Friday will be an important day. I’m writing this as of Thursday’s close, so I don’t have a weekly close to work off.) Conversely, a close above last week’s high means I’m wrong and the ECB-reaction was just a head fake, and that the recovery has more room to run.