Russia’s central bank yesterday abandoned its policy of unlimited FX intervention in support of the ruble. This precipitates the shift to a freely floating exchange rate regime which was due to commence only in 2015. The move came in response to continued capital outflows, which had led to a 35% decline against the USD since June, a $71 bn loss in reserves (-15%) from October 2013 and a rise in interest rates by 400bps to 9.50% since the start of the year.
As ECB policy rates skirt the zero bound, expectations for the use of alternative tools, such as negative deposit rates are again on the rise. However, this is an ineffective and potentially harmful policy option.
Several problems may arise: transmission across other rates in the financial system is not guaranteed, bank profitability would almost certainly suffer, logistical problems could arise from a massive shift into physical cash and , most importantly, the ECB’s balance sheet would contract, just when the opposite is required.
More useful would be measures aimed at the de-fragmentation of EZ financial markets, such as a selective asset purchases or lending against a differentiated set of collateral rules.
Yet, it is questionable whether policies targeted at reigniting lending are sensible at all when the private sector is in a de-leveraging phase and impediments to growth are primarily structural.
The Fed surprised markets with a more hawkish posture than expected, suggesting the start of QE tapering in late 2013 and completion by mid-2014.
While Fed guidance may not ultimately come to pass, EM equity markets in particular remain subject to further downside. True, this year’s sell-off has been much more rapid than when QE ended previously. But its scale so far is similar-to-smaller.
The market sell-off may thus slow a bit or retrace temporarily, but EM equities are particularly vulnerable to a withdrawal of capital inflows.
The numbers involved are small. Yet, the Troika/Cyprus move to renege on deposit insurance and appropriate private funds is set to reverberate beyond the tiny island.
The decision bodes ill for future rescue efforts: 1) it derails popular support for any adjustment plan, 2) it reveals the ECB’s promise to do “whatever it takes “ and engage in unlimited OMTs as an empty bluff, 3) it puts the nail in the coffin of the putative European banking union and 4) it turns the plan to create a well-understood resolution regime and creditor hierarchy on its head.
All these serve to undermine the credibility and hence the efficacy of any future rescue attempt in the Eurozone.
Bill Gross argues that credit is losing its power and suffers from entropy, destined to a fatal supernova end. But pay heed to the power of compound interest and the fact that correlation does not establish causation and it is clear that PIMCO’s analysis is nothing but a fallacy of galactic dimensions. Continue reading →
Recent market perceptions notwithstanding, the Fed is unlikely to end its accommodative stance (incl. QE) anytime soon. However, this does not mean that asset markets will continue to derive undiminished support from such actions forever.