The ECB Has More at Play — and Risk — Than the Fed

Italy and the Risk of Fragmentation

As of Wednesday, it appears that the resignation of Mario Draghi as Italy’s prime minister is at last a done deal. That amps up uncertainty, which in turn tends to amplify the spread between the yields on Italian and German bonds. This is a key measure of political risk, or specifically of the risk that the eurozone begins to fragment. The more aggressively the ECB chooses to hike, the greater the concerns over the Italian economy, so Italian yields rise by even more, taking the spread even higher. Italian political drama on the eve of a rate decision is thus as unwelcome a development as bank President Christine Lagarde and her colleagues could possibly imagine.

Whatever the ECB chooses to do, it’s going to have to produce good and convincing details on how it can stop this spread widening further. If there was any doubt over this, Italy’s latest political crisis has removed it.

Europe’s Banking System

Unlike the Fed, whose decisions on credit are generally refracted through markets, the ECB must contend primarily with the banking system. That’s a problem because Europe’s banks have been far weaker than those of the US ever since the Global Financial Crisis. And the latest edition of the ECB’s quarterly survey of senior lending officers at eurozone banks show that both the supply and the demand for credit are falling rapidly.

Most awkwardly for the ECB, the health of the banks tends to accentuate the fragmentation risks within the eurozone. This is the assessment by economists at Barclays Plc:

Credit conditions have continued tightening, and incrementally so in peripheral economies. The tightening in credit standards — now at their tightest level since 2012 — has been driven by increased risk-aversion, due to elevated uncertainty, and lower risk-tolerance as economic conditions are on a worsening trajectory. Across countries, credit standards have deteriorated in Italy, France, and Spain, while remaining unchanged in Germany. The results of the BLS provide further confirmation..: We expect a reversal of the decade-long monetary policy easiness to have an asymmetric impact across countries, especially acute in countries where the sovereign-debt nexus is strong (eg, Italy and Spain).

This chart from Barclays shows the pattern clearly. A rise means that credit standards have tightened (meaning the credit is harder to come by), and the chart also shows the different reasons given by banks for why they thought credit was tightening:

On top of all this, the ECB wants to start withdrawing its support for the banking system through the “TLTRO” (targeted longer-term refinancing operations) loans, with which it has been easing pressure on banks. The terms are generous and this makes sense — but again, Barclays warns that it could have greater impact in peripheral economies. In short, the banking system could multiply any monetary tightening to take it to a dangerous level.

Energy

Europe is not just waiting for the ECB to announce new interest rates; Thursday should also give some formal indication of how much energy Russia is prepared to provide, as maintenance work on the crucial Baltic Nord Stream pipeline is due to be completed. This is what has happened to the forward price of natural gas in Germany over the last two years:

The latest words as of Wednesday were not encouraging. Vladimir Putin, Russia's president, said the pipeline was reopening, but with conditions. As Bloomberg reported:

Putin made clear that if a pipeline part that was caught up in sanctions isn’t returned to Russia, then the link will only work at 20% of capacity as soon as next week — as that’s when another part that’s now in Russia needs to go for maintenance. After frantic diplomatic efforts by Germany, the turbine is on its way home from Canada.

The stakes are high. According to the International Monetary Fund, cutting off Russian energy could on its own cause the German economy to shrink by almost 5%. In a genuine cliffhanger, we must await dawn in central Europe on Thursday — roughly when this newsletter should be reaching you — to see how much gas is actually getting through. Late Wednesday, the head of Germany’s grid said that Russia had arranged for the pipeline to work at 30% capacity. Within a few hours of the pipeline moment of truth, the ECB will need to say what it’s doing about monetary policy.

Despite all of these constraints, the market, as measured by Bloomberg’s World Interest Rate Probabilities function, does see a very slight chance of a 50-basis-points hike in July, which would bring the ECB’s target rate up the heady heights of 0%. Meanwhile, the last week or so has seen a hardening in the belief that the rate will have risen beyond 1% by year’s end:

If the ECB really does go full hawk and hike by 50 basis points, we can expect the euro to surge well above parity with the dollar. If it doesn’t, and fails to offer a convincing plan to stop eurozone fragmentation, a dollar could be worth more than a euro for a while. It must be very hard to be Christine Lagarde.

Are We There Yet?

Stocks have suffered a dreadful first half of the year, even though the US economy remains robust for now, and in recent days share prices have begun to show signs of life. That leads to the question that the kids tend to ask from about the second they get into the car: “Are we there yet?” I think the answer is: “Probably not, unless things break much better for the economy than seems likely at present.” But that hasn’t stopped any number of technical analysts and strategists weighing in on the issue over the last few days. Isabelle Lee has collected some of the more interesting prognoses:

Bespoke Financial:

One matter of excitement for technical analysts is that the S&P 500 has just broken its longest streak below its 50-day moving average since the GFC. Long streaks of trending downward used to be common — but not in the QE-dominated decade after the crisis:

How much significance should we attach to this? Some, but not that much. This is Bespoke’s conclusion:

For the S&P 500, the streak ending at 60 trading days was the longest since the 72-day streak ending all the way back in 2008, and it was just the 19th streak of 60 or more trading days in the post-WWII period. Now the S&P 500 just needs to work up enough strength to get back to its 200-DMA which is still 10.7% above yesterday’s close.

So the way a technician looks at this, the brutal headlong descent may have ended, but the market is still a long way from establishing a clear new upward trend.

Ned Davis Research:

Exploring whether stocks are now cheap enough to justify buying, Ned Davis comes up with a resounding “perhaps”:

Based on earnings yields alone, valuations have improved. As shown above, the trailing earnings yield for the All Country World Index has risen from a low of 3.3% to its current level of 6.1% while the ACWI’s forward earnings yield has risen from 4.8% to 7.1%. Both are above their medians since 2003, as shown in the chart’s box. While the improvement is encouraging, it may not be enough if it becomes increasingly evident that a global recession is developing.

Improvement is also evident when comparing earnings yields and bond yields, a relative valuation assessment indicating that equities are better valued. Among 41 MSCI indices, the median spread between a country’s earnings yield and its 10-year government bond yield is four percentage points. Up from a low of 2.1 percentage points last year, the spread has widened despite the bond yield uptrend over the period.

This has been another hopeful development, especially now that bond yields have turned downward. But as with earnings yields alone, the improvement may not be enough if we’re entering a severe global recession, considering that the spread exceeded six percentage points at its extreme in 2020 and was more than eight percentage points at its high in 2009

Stocks are an undeniably better buy than they were. Unless you’re confident you can gauge the extent of the economic damage, however, they’re still not a clear buy.

LPL Financial

There has been great excitement about market “breadth”; broad-based advances including the great majority of stocks inspire greater confidence than narrower advances. And this week saw the broadest advance for the S&P 500 (defined as the number of advancing stocks minus the number of decliners) since the day after Christmas in 2018, when there had just been a spectacular selloff:

Back at the end of 2018, the day of exceptional breadth proved to be a watershed, and the stock market went on a new rally. But LPL Financial prodded the breadth data a little more, and suggested that we need far more evidence before declaring a turn:

The next stage we would like to see would be some real signs of investor enthusiasm for buying stocks. For the most part over the past month, the data there has been lackluster. The best performing areas of the market have been oversold growth sectors, such as discretionary and technology, but defensives are close behind and cyclical value has been flat to lower over the time. In fact, 25% of stocks in the S&P 500 are actually lower than they were a month ago, and the percent of stocks up above their respective 200-day moving average has only nudged up slightly, from 13% then to 18% as of Monday. Not exactly impressive.

Bank of America

Analyzing their data on investors’ exposures, BofA found that large speculators had “their most aggressive, or contrarian bullish, net short in SPX futures as a percentage of open interest since the depths of the Covid-19 pandemic.” That means that the conditions are in place for a big rally if those speculators are given a good reason to think that they should get out of those positions. As BofA added:

Other major lows for this indicator occurred in late 2015/early 2016 and late 2011, which were near important market lows. The asset manager net long in SPX e-mini reached the lowest levels since 2016, 2015 and 2011 in late June.

So to summarize — the direction of the market, and its breadth, are both consistent with what we might expect to see if a major low were near, while the extreme negativity, shown in surveys as well as in positioning data, provides the fuel for a big bear market rally. But none of this is compelling enough to justify diving into the market with so much economic and geopolitical uncertainty around. The initial vertiginous phase of this bear market is over; we need far more evidence from the real world before we can tell whether the bear market itself is over.

Blue on Blue

In Britain, Conservative MPs have somehow managed to narrow their field down to two prime ministerial candidates who served at the top of Boris Johnson’s cabinet and who both did the same degree at the same university. While diverse in other important ways, this doesn’t augur well for avoiding groupthink in government, as I wrote here.

However, very strangely, this election looks as though it will end up being a crucial debate over how to run the economy, with a deep philosophical difference between Rishi Sunak — in favor of balancing the books, with tax hikes if necessary — and Liz Truss, who favors big spending and tax cuts combined with what she appears to suggest will be a much more hawkish monetary policy. This is the big differentiator between them, and it concerns by far the most important issue facing the country, so the British are likely to spend the rest of this hot summer watching a classic debate over the core principles of how to run an economy.

This is important. Economics always matters, but when it comes to political outcomes in recent decades other issues have tended to get in the way. The choices between Biden and Trump or Macron and Le Pen were far more dominated by cultural issues such as immigration than they were by economics. British politics for decades has been about Europe writ large. Now, we get to find out whether the 200,000 or so members of Britain’s Conservative Party, who tend also to be personally conservative, are more attracted by a bold libertarian expansion (a la Truss) which implicitly incorporates a Keynesian belief in spending money, or a traditional conservative attempt to avoid deficits.

Austerity, pursued with great enthusiasm in Britain under David Cameron, has been widely pilloried. Could this be the point when a long-brewing political transition is completed and a “left-wing” economic policy becomes the doctrine of a “right-wing” party? Republicans under Donald Trump did something similar to what Truss is suggesting by passing huge unfunded tax cuts (with the significant difference that monetary policy got very easy once things grew difficult). If Britain’s Conservatives also throw their weight in with this approach, it will begin to look as though the prevailing economic philosophy of the last four decades suddenly has no significant politicians ready to argue for it. It matters a lot.

Survival Tips

Returning to British politics, it often makes me want to scream with frustration, but it’s always entertaining. This leadership campaign is already up there with such fictional excitements as Jim Hacker’s riding into Number 10 on the back of the British sausage in Yes, Prime Minister, or Malcolm Tucker’s profane delight in bringing down party leader Nicola Murray, and the departure of adviser Stewart Pearson in Armando Iannucci's brilliant The Thick Of It. And then there was the original “House of Cards,” featuring a chief whip, Francis Urquhart, who was even nastier than Frank Underwood. Enjoy — British politicians are going to give us some light relief in a hot summer.

Bloomberg News provided this article. For more articles like this please visit bloomberg.com.

Read more articles by John Authers