The European Central Bank as Game Changer?
Mario Draghi, the new president of the European Central Bank (ECB), has had a remarkable first 100 days. His first official act was to reduce interest rates. A debut "con fuoco", so to speak: In taking this step Draghi corrected his predecessor's excessively restrictive monetary policy. And he did so despite the risk of being accused, as an Italian, of favouring Italy by pursuing a "Mediterranean motivated" expansionary monetary policy. Subsequently, he cut interest rates again. There can be no doubt that his decision to loosen monetary policy is the right one. The inversion of the yield curve – a phenomenon in which yields on longer-dated bonds are lower than yields on short-term money market paper – indicates that under his predecessor, Jean-Claude Trichet, monetary policy was far too restrictive in 2011.
Mario Draghi's second important measure was to create a funding facility that provides large amounts of cheap liquidity with a three-year term to maturity. The program, known as longer-term repo operations (LTRO) has noticeably reduced the risk of a systemic crisis in the European banking sector. The success of the scheme is reflected in the improvement of various risk indicators: In January, there was a marked decline in the credit default swap (CDS) premium demanded to insure against defaults on bank bonds. Moreover, the so-called EONIA spreads – a gage of uncertainty in the banking system – have narrowed. The narrowing of the differential between corporate bonds and government bonds is another sign that the economic environment has stabilised, and in some places even improved, at least for the time being. The most recent German and U.S. economic data confirm this development: U.S. employment data were surprisingly strong. In Germany businesses were generally more optimistic about the future, as expressed in the improvement in the ifo Business Climate Index.
American monetary policy authorities continue to maintain an extremely accommodative stance. The Federal Reserve intends to keep interest rates close to zero until late 2014. With its announcement the Fed has gone out on a limb; just how far ahead monetary policy can be predicted is the Fed's secret. For the moment, though, the monetary watchdogs in the U.S. have set a target against which their actions can be measured. At any rate, the announcement was good news for the financial markets. All in all, the environment for riskier asset classes has improved, even if mainly through measures to increase liquidity. Working on the premise that the euro crisis will stabilise somewhat in the course of the year – though a resolution is still in the distant future since a bold plan such as a fiscal union would take more than ten years to realise – equities, corporate bonds and the bonds of selected emerging markets are likely to be attractive. Markets will remain volatile for a while on account of existing uncertainties in connection with the unresolved problems surrounding Greece, as there is a very real danger that a Greek default could cause contagion to spread to other countries on the euro-periphery. This is the chief risk this year. That said, sooner or later investors will again focus on economic fundamentals and realise just how cheap certain equities and equity markets are.