Friday, June 24, 2011
I've gotta say, I have absolutely no idea why the ECB is hiking. If I look at key monetary variables (forget about the real economic data for a minute), they should be on hold.
(1) inflation expectations has dropped off precipitously across key countries in Europe, as measured by the 10-yr swap linker. One could argue that it's simply market sentiment and oil - which could very well bounce back - but the same measure of US inflation expectations is sticky at 2.7%. Chart 1 below.
2) key monetary variables, the annual growth in the money supply (M3) and lending to euro area residents have tapered off at levels not seen since 2003, with exception to recent history. On a 3-month annualized basis, growth rates have slowed markedly from peak levels earlier in Q1 2011 (MFI loans) and Q3 2010 (M3 growth). Charts 2 and 3 below.
(3) A cursory view of the history of ECB rate targets, US Fed rate targets, and the monetary variables suggests a high correlation between US Federal Reserve policy and Euro area monetary variables. In fact, on a 3-month annualized basis, MFI lending to Euro area residents has a 70% correlation to US Fed policy, a much greater correlation than with ECB policy (50%) - this same correlation is more balanced at the % Y/Y level. Chart 3 below.
(4) The money supply has a high correlation to ECB policy using either the Y/Y or the 3-month annualized growth measures. Money supply is a lagging indicator (one of the lengthier lagging indicators) - I would go so far as to deduce that this high correlation is further indication that the ECB is a 'reactive' bank.
It's going to be very tough for the ECB to eke out another 25 bps, let alone 50 bps by year end (the market is pricing in roughly 40 bps of hikes by year end). The economic (not this article) plus monetary data don't even support it.