Europe’s Central Bank Is the World’s Most Important

Over the next two weeks, investors will focus on monetary policy ahead of the European Central Bank meeting on June 8, which will be followed by the Federal Reserve on June 13-14.

After a disappointing U.S. jobs report for May and amid signs of a regulatory crackdown on Chinese credit growth, fissures are appearing in the global reflation consensus. With Treasury yields dipping at the end of last week to their lowest levels in six months, the deliberations of the world’s major central banks take on added importance.

Some market participants are beginning to fret that U.S. and global growth will slow significantly in the second half of 2017. They worry that the Fed has already been too hasty in lifting interest rates, to say nothing of discussions to shrink its balance sheet by year-end.

Those concerns appear premature. Seasonal factors probably contributed to the weakness in the latest employment report. Other data, including jobless claims, ADP or purchasing manager indices portray an economy that is, if anything, gaining momentum after a sluggish start to the year. Elsewhere, global economic data show few signs of weakness.

For bond investors, the Fed may not even be the focal point. Arguably, the title of world’s most important central bank has passed to the ECB. In recent years, as the ECB expanded its asset purchase program and adopted negative interest rates, European bond yields have exerted a powerful impact on global yields, including those for U.S. Treasuries.

That’s new. Over the past five decades statistical analysis has shown that causation had only run one way — from Treasuries to Bunds. But since 2015, when the ECB went “all in” on monetary accommodation, movements in European bond yields have had at least as large an impact on Treasury yields as the other way around.

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Now, with European growth likely to reach 2 percent in 2017 — a marked improvement compared to when the ECB initiated aggressive easing — many, and not just traditional hawks, are beginning to ask when the Governing Council might declare “mission accomplished.”

Such a move could have huge effects. Even a subtle shift in ECB forward guidance could unleash a German taper tantrum, reminiscent of the bond market backlash to Fed tapering in mid-2013. Given that bond investors have recently piled back into longer duration positions, the risk of a negative market shock this week from the ECB is that much greater.

Yet the real power player here is neither the ECB nor the Fed. The primary reason why bond markets have rallied since March is receding inflation risk, and not concerns about global growth. The latter remain figments of the Cassandras’ imagination, rather than an accurate reflection of recent economic data. If anything, global growth has accelerated modestly in the second quarter, a key reason why many global equity indices are flirting with record highs.

Inflation, on the other hand, remains at bay. Moreover, as energy base effects recede, inflation rates are once again declining. At the same time, core inflation shows few signs of picking up, despite tighter product and labor markets. U.S. core measures have moved lower and euro zone core inflation has hardly budged in the past half year from a level just below 1 percent.

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At this stage in the cycle, inflation dynamics are crucial for monetary policy. In particular, without signs of budding price pressures it is difficult to see ECB President Mario Draghi and the majority of the Governing Council taking decisive action to change policy.

Moreover, though few central bankers may want to admit it, most of them are probably scratching their heads about the absence of the traditional trade-off between unemployment and inflation — the Philips Curve.

Fed Chair Janet Yellen, Draghi and many of their colleagues must be perplexed about what is not happening in Japan. There, despite evidence of an extraordinarily tight labor market — the ratio of job vacancies to job seekers is at levels last seen five decades ago — wage inflation remains moribund. The Japanese Philips Curve is nowhere to be seen.

The bottom line is that market speculation about which central bank — the Fed or the ECB — matters most is largely beside the point. Inflation, or its absence, is what really matters. When it comes to bonds, it’s not so much about Draghi or Yellen. Rather, it’s all about the Philips Curve and, at least thus far, its absence in the data.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Larry Hatheway at [email protected]

To contact the editor responsible for this story:
Max Berley at [email protected]