Don’t hold your breath for some magic from the ECB

This has led to serious concerns about the outlook for regional growth and inflation, and raised expectations for a further loosening of monetary policy from the European Central Bank. But will the magic man, ECB president Mario Draghi, pull a rabbit out of the hat?

At the time of writing, the consensus estimate for eurozone inflation for August is 0.3 per cent year on year — a worryingly low figure — and the number will come out ahead of the ECB’s September meeting. Expectations for further easing are pretty high after Draghi’s Jackson Hole speech, in which he stated that the ECB governing council acknowledged the recent drop in markets’ inflation expectations.

One of the key tenets of Mr Draghi’s ­argument in the past against a bond-buying ­programme — or quantitative easing (QE) — that inflation expectations are ­firmly anchored, no longer holds. Five year five-year inflations expectations (that is not a typo, its market expectation of what inflation will be in five years time, five years from today) have fallen recently, dipping below 2 per cent. In the shorter term, the two year two-year inflation expectations have fallen even more sharply.

The downbeat inflation expectations are naturally being reflected in bond ­markets, and particularly the yield on the German government bond. The yield on the 10-year Bund fell to 0.93 per cent on 25 August, a record low and lower than during the height of the eurozone crisis, when demand for safe haven assets was at its highest.

This has pushed the spread between ­German Bunds and US Treasuries to 146 basis points. However, this spread is not actually that unusual in the current ­climate. The US Federal Reserve (the Fed) and the ECB are at different stages of their monetary policy cycles, as the eurozone economy has stagnated while the US economy has been relatively robust, and inflation in the US is not far off the Fed’s target.

Geopolitics will also be having a larger impact on Europe. The Ukraine/Russia conflict is weighing more on Bund yields than other core government bond markets, given the closer economic ties between ­Germany and Russia, as well as the still-unknown impact of sanctions. Business and consumer surveys from Germany certainly highlight these concerns and have been much weaker than expected recently. While central bankers are powerful people, Draghi has very little control over where the tanks are parked in eastern Ukraine.

It is increasingly looking like the ECB will take further policy steps before the year is out, but I do not think we will see the bazooka of outright QE that the market is currently expecting. Although QE is definitely on the table and we may see it introduced next year, the form that it would take is anyone’s guess.

There is likely to be more tinkering around the edges of the package announced in June for targeted long-term refinancing operations. The first TLTRO comes into effect in September and the ECB will want to see a strong uptake from banks for the cheap funding to boost sentiment in the region and bring up the flagging inflation expectations.

Further down the line, the ECB will want to digest the impact of the TLTROs on bank lending and the market reaction to the announcement of the bank stress tests.

The ECB can only do so much. The fate of the eurozone rests in the hands of individual governments, as fiscal and monetary policy cannot compensate for a lack of ­structural reform — the actions of the ECB do not relieve governments of the reform burden.

The fate of the eurozone rests in the hands of individual governments

Finally, it is worth remembering that the hurdle to full QE is still high. Even if the Germans appear to have warmed to it, it is still politically difficult and, more importantly, implementation is problematic.

The ECB will want to be sure that it is an effective policy that will have the desired impact before heading down a path of no return. For now, the rabbit stays in the hat.

Kerry Craig is global market strategist of JP Morgan Asset Management