Market Pulse
  •  
Jul 2019
Expect the Unexpected from the ECB
 

Market Pulse

Expect the Unexpected from the ECB

Expect the Unexpected from the ECB

Share Icon

Jul 2019

 
 

The July European Central Bank (ECB) monetary policy meeting pretty much confirmed that policy is likely to be eased in September. The interim period will be used to build a consensus in the Governing Council around what exactly the policy response should be. Guided by some pretty explicit language in the statement, our expectation is for the ECB to announce a package of easing measures, most likely including rate cuts, changes to its forward guidance, renewed quantitative easing (QE), and mitigating measures to offset some of the cost of more negative interest rates on the banking sector. While the main measures may be easy to anticipate, the unexpected details may matter more: the ECB under Draghi has excelled at surprising the market with its dovishness by coming up with policy measures that few anticipated; we expect the same at his swan song. 

 
 

This ECB meeting was important because it confirmed a shift in monetary policy bias which President Mario Draghi signalled at Sintra in mid-June. In that speech he stated that “In the absence of improvement … additional stimulus will be required,” a clear indication that the ECB was far closer to easing monetary policy than previously thought. Prior to that it stood ready to act only if things got worse; now he was saying things needed to get better for the ECB NOT to act. 

It was not definite following that speech if ECB policy had changed, as several Governing Council members gave speeches or interviews which suggested easing would only happen if things got worse. However, the July ECB meeting confirmed that, unless things got suddenly better, an agreement to ease policy was reached even if there was no agreement yet on what exactly those easing measures should be. It seems that, once again, Mario Draghi has moved ahead of the rest of the Governing Council, and then pulled it in line with his thinking. 

So what caused the ECB to change its position, and what policy options are likely? 

The reason for the change is not immediately obvious because the recent Eurozone macroeconomic environment, while not exactly flourishing, has not been struggling too badly. The manufacturing sector is weak, but the labour market and construction sectors remain strong. We think the change comes from three factors: 
first, Eurozone core inflation has failed to pick up, despite the fact that the labour market has tightened and wage growth has been robust for some time now; 
second, both survey and market-based measures of medium-term inflation expectations, i.e., inflation breakevens have fallen this year, casting doubt about whether the ECB can achieve its inflation mandate; third, the ECB continues to worry about international geopolitical and trade risks, which pose hard-to-predict downside threats to the Eurozone economy. 

As Draghi stated explicitly, the ECB is currently failing on its inflation mandate, and is increasingly not expected to achieve it any time soon, all while the economy is not getting better. The Governing Council does not like what it sees. 

So the ECB needs to act, not only because it is failing to meet its inflation mandate and believing risks are skewed to the downside, but also because it is concerned about losing credibility as a central bank that specifically targets inflation. This is slightly different to the situation in which the U.S. Federal Reserve (Fed) finds itself, where moderate inflation gives it leeway to ease if it wants. For the ECB, weak inflation is forcing it to act. 

In terms of policy response, we think the ECB is likely to announce a package of easing measures in September. This is something it has favoured doing in the past, as a collection of complimentary policy initiatives is more effective than a piecemeal approach. It is debateable whether the ECB has a big policy “bazooka” left, so getting the most out of the tools it does have is important, and getting maximum “bang for the buck” involves combining them. Given the details given in July’s announcement, the package we envision is: 

  • A 20 basis point cut in the Deposit rate: rate cuts were not mentioned in July’s release, but the ECB hasn’t pushed back on the market pricing in of cuts, and the mention of “mitigating measures” (see below) suggests they are likely. In our mind, cutting by less than 20 basis points achieves little, and cutting more may be counterproductive due to the negative impact on the banking sector. Rate cuts are the conventional tool for central banks to stimulate the economy, and Draghi has highlighted their effectiveness in the Eurozone given their impact on the currency, i.e., rate cuts should provide additional stimulus and inflationary pressure if they cause the euro to depreciate. 
  • Changes to forward guidance: the guidance the ECB provides on when it plans to change interest rates and other policy settings in the future is a key tool, as it enables it to influence interest rates across the yield curve. As in the past, it may be combined with QE and other measures (e.g., the ECB will not raise interest rates until after it has finished new QE purchases). 
  • A resumption of the QE programme: July’s statement referred to “options for the size and composition of potential new asset purchases.” So we do not only expect a resumption of quantitative easing, but changes to the parameters of the previous programme as well. An increase in individual issuer limits to 40% or 50% will be necessary to make a new programme credibly large, but we will also be keeping an eye out for any innovative additions to purchases, like senior bank debt. 
  • Mitigating measures to offset the rate cuts: it is estimated that the negative interest rates banks currently “earn” on their ECB deposits actually costs them EUR 8 billion per year, although the cost falls mainly on northern European banks rather than being evenly spread across the system as a whole. A tiering system, whereby a higher rate is paid on some initial portion of a bank’s excess reserves, would alleviate some of the cost, although the programme would need to be carefully designed not to raise money market interest rates, which would reduce the effect of cutting rates. 
  • Something else: the ECB, under Draghi, has excelled at developing innovative policy initiatives. His reputation for surprising the market primarily comes from designing policy measures investors didn’t anticipate, rather than doing more of what they were expecting. We’re not quite sure what the ECB might pull out of its “bag of tricks” this time, but we wouldn’t be surprised to see something different from just vanilla rate cuts, more QE and forward guidance. 

If we’re correct about our expectations, what do we think the impact on fixed income markets is likely to be? The market has already priced in more than 20 basis points of rate cuts by the end of 2020, so we think the fall in the yield of German government bunds, and other high quality government issuers, is limited, even if they are once again supported by renewed ECB buying. However, we expect euro sovereign spreads to tighten as yieldhungry investors are forced into holding lower-rated paper. Sovereign spreads have already tightened significantly this year – for example, 10-year Spanish bonos now only yield 70 basis points more than German bunds, down from nearly 130 basis points in early January. However, the fiscal fundamentals of most of these countries have also been improving, justifying tighter spreads. We think there is more to go. 

 
 

RISK CONSIDERATIONS
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the Portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities ("junk bonds") are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).

 
 

July 2019

 
anton.heese
 
Executive Director
 
 

IMPORTANT DISCLOSURES

Past performance is no guarantee of future results. The returns referred to in the commentary are those of representative indices and are not meant to depict the performance of a specific investment.

The views, opinions, forecasts and estimates expressed of the author or the investment team as of the date of preparation of this material and are subject to change at any time due to market, economic or other conditions. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

This material is a general communication, which is not impartial, and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

DISTRIBUTION
This communication is only intended for and will be only distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s/product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

United Kingdom: Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA. Dubai: Morgan Stanley Investment Management Limited (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). Germany: Morgan Stanley Investment Management Limited Niederlassung Deutschland Junghofstrasse 13-15 60311 Frankfurt Deutschland (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Ireland: Morgan Stanley Investment Management (Ireland) Limited. Registered Office: The Observatory, 7-11 Sir John Rogerson's, Quay, Dublin 2, Ireland. Registered in Ireland under company number 616662. Authorised and regulated by Central Bank of Ireland. Italy: Morgan Stanley Investment Management Limited, Milan Branch (Sede Secondaria di Milano) is a branch of Morgan Stanley Investment Management Limited, a company registered in the U.K., authorised and regulated by the Financial Conduct Authority (FCA), and whose registered office is at 25 Cabot Square, Canary Wharf, London, E14 4QA. Morgan Stanley Investment Management Limited Milan Branch (Sede Secondaria di Milano) with seat in Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy, is registered in Italy with company number and VAT number 08829360968. The Netherlands: Morgan Stanley Investment Management, Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. Telephone: 31 2-0462-1300. Morgan Stanley Investment Management is a branch office of Morgan Stanley Investment Management Limited. Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: Morgan Stanley & Co. International plc, London, Zurich BranchI Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-115.415.770. Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland, Telephone +41 (0) 44 588 1000. Facsimile: +41 (0) 44 588 1074.

Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This material has not been reviewed by the Monetary Authority of Singapore. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

Japan: For professional investors, this document is circulated or distributed for informational purposes only. For those who are not professional investors, this document is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”). This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions. All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.16% per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This document is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: The Japan Securities Dealers Association, the Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

U.S.: A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

Please consider the investment objective, risks, charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the fund. To obtain a prospectus, download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley funds.

NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT

IMPORTANT INFORMATION
EMEA: This communication has been issued by Morgan Stanley Investment Management Limited (“MSIM”). Authorised and regulated by the Financial Conduct Authority. Registered in England No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.

The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.

This document may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this document in another language, the English version shall prevail.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent.

Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

All information contained herein is proprietary and is protected under copyright law.

 

Check the background of our firm and registered representatives on FINRA's BrokerCheck

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.

Not FDIC Insured—Offer No Bank Guarantee—May Lose Value
Not Insured By Any Federal Government Agency—Not A Deposit

Privacy & Cookies    •    Terms of Use

©  Morgan Stanley. All rights reserved.

Morgan Stanley Distribution, Inc. Member FINRA/SIPC.