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Has the ECB gone mad?

Even though growth is looking good, and inflation is on the way up, further monetary easing by the ECB makes sense.

By Bo Bejstrup Christensen, chief analyst at Danske Invest

Interest rates in the euro area have declined further in recent weeks – with the yield from two-year German government bonds falling to approximately -0.4 per cent. Money-market rates have also decreased. This movement is driven by the expectation of further easing by the European Central Bank, ECB, whose president Mario Draghi at the meeting in October virtually promised that further monetary policy easings are on the way.
But why? We have just had the best business confidence indicators for several years, growth seems to be around 2 per cent, and inflation is finally on the way up. Why a further easing right now? Has the ECB gone mad?

Risks mounting up
No! It is our view that the ECB is acting completely rationally – and correctly. Even though the economy currently seems to be doing well, with falling unemployment and sound growth, there are some dark clouds forming on the horizon. Several temporary factors are currently pushing growth along. The primary examples are the falling oil price and weaker currency. Yet these are still temporary factors. Unless the oil price takes a new plunge, or the currency weakens significantly as a consequence, the economy will quite simply no longer benefit from these fair winds. Combined with concerns about growth in the emerging markets and the current geopolitical uncertainty, we suddenly begin to see a future growth scenario that is not quite so interesting. Even though we– and the ECB – can point to a healthier banking system to support future growth, there is a significant risk of declining growth in 2016. Especially if the ECB does not do anything.

A long way to the inflation target
Lower growth will suddenly make it more difficult to achieve the ECB's inflation target. Combine this with the experience from the USA, where the economy is now growing for the seventh consecutive year– in marked contrast to the euro area, which has only just begun to grow again after several years of crisis. Meanwhile, inflation is still not back at the desired level, and we are beginning to see an outline of a European Central Bank that will find it hard to achieve its inflation target within the foreseeable future. Finally, inflation has now been so low for so long that there is a risk that it will become a self- fulfilling prophecy.

ECB will introduce an easing this week – by a lot!
At the beginning of the year, we expected that the ECB would not ease monetary policy again until 2016. They have therefore surprised us by doing this earlier – because we now expect an easing at the meeting on 3/12.  We are pleased about this, since this depicts a central bank that is far more forward-looking than before - for the benefit of growth and the financial markets. The ECB will therefore further lower its interest rate and extend its bond buying programme.
We also believe that it is very likely that the ECB will both expand the programme and thereby the assets it will buy, while becoming more specific about how long it intends to buy e.g. government bonds. This might entail an objective for how much unemployment must decrease before the ECB begins to reduce its bond buying.

Good news for European equities – although bond yields are close to rock bottom
Fundamentally, this considerably eased monetary policy is good news for European equities, and if we are right about the ECB's significant easing, this can push equities up even further. Even though we believe the ECB is easing rather more than the fixed income market is currently discounting, we do not think that the long-term bond yields will fall much more, partly because the aggressive monetary policy is good for growth and thereby inflation in the longer term. 
In overall terms, there is thus a prospect of continuously very low interest rates in the euro area, but also rising equity prices. And hopefully continued sound growth now that the ECB is easing monetary policy again!
 

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