European Central Bank – Tightening Could and Should Accelerate

Last week the European Central Bank (ECB) released the minutes from its rate-setting meeting in December and the notes revealed that the bank’s tightening strategy could move faster than originally anticipated. This revelation came just a few days after the Bank of Japan (BOJ) released a similar statement. The BOJ revealed that it had made fewer bond purchases than investors anticipated.

The move comes as the EU’s annual GDP growth rate is close to what it was before the financial crisis in 2007, but it hasn’t moved above the 3.0 percent level in the last ten years. Plus we have to consider what is going to happen once Britain is no longer part of the equation.

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After the report was released the Euro rallied sharply against the Dollar and bond prices dropped, driving rates up and causing German bond yields to reach a two-year high.

Like the Fed, Bank of England and BOJ, the ECB has to weigh inflation versus growth and the central banks have rarely gotten the timing right as history shows. The risk is that you raise rates too quickly and that causes an economic slowdown. The Fed has been pretty clear with its intentions, stating that they foresee at least two more rate increases this year. The ECB hasn’t started raising rates yet, it has only backed off of its bond buying.

This begs the question, what is going to happen when the ECB raises rates from the zero percent rate it has been at since March ’16? If the Euro rallies and bonds drop as sharply as they did last week just on a bond-buying cutback, how sharply will the Euro rally and how sharply will bonds drop on an actual rate hike?

Personally I think the ECB is in a tough spot. They have to back off the QE in order to appear just as strong as the U.S., England and Japan, but they can’t raise rates while they are still buying bonds. It seems like the ECB is behind the curve and you could say that the BOJ is as well. Neither has started raising rates while the Fed has raised rates three times in the past year.

It is also interesting to look at the exchange rate between the Euro and the Dollar. Over the past year the Euro has rallied against the Dollar, even though the Fed has been raising rates. A strong currency that is rising against other currencies causes imports to become cheaper, but causes the exports to become more expensive. In a strong economy, a strong currency is not all that bad, but if the economy isn’t really strong, a strong currency can squelch growth attempts as the demand for costlier exports slow the economy.

What is really interesting is that historically as interest rates rise in one country or region, the currency of that country or region tends to rally against other currencies as the higher interest rates attract foreign investment. To see the Euro rallying against the dollar while the ECB keeps rates at zero and the Fed has hiked three times is a bit of a conundrum. Will the Euro continue rising against the Dollar when the ECB does finally raise rates? That could really hurt the economic growth of the EU. And if the economic growth suddenly slows for one reason or another, now the ECB is really in a rough spot as they have little room to cut rates.

From my perspective, the ECB needs to speed up its tightening measures or risk getting caught in an impossibly tough situation of having a strong currency, a slowing economy and little wiggle room with interest rates.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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