Draghi and the Old Lady under Investors’ Watchful Eyes

The eurozone and the United Kingdom may be bound by virtue of the European Union, but the two regions are on vastly different paths with respect to economic recovery following the 2008 credit crisis and the Great Recession that laid the world low.

While the eurozone continues to struggle against deflation and unemployment, the U.K. has posted an incredible turnaround. In fact, the U.K.’s recovery surprised even the Bank of England (BoE), prompting observers to criticize the central bank for not being up-to-speed with the pulse of the economy. Now financial markets will bear witness to these states’ differing fates as the BoE and European Central Bank (ECB) face public scrutiny on Thursday. The main message from both will be along the same lines: economic recovery remains fragile, and therefore, record low interest rates are the order of the day. What will be interesting to watch unfold is how the market views these messages and how investors will position themselves based on their future expectations.

Not too long ago, the market was so impressed with the U.K.’s rocketing fortunes it pegged the BoE to be the first major central bank to hike its interest rates. Governor Mark Carney tried to get ahead of the economy and he was supportive of rate hikes initially, but he backtracked as his public remarks got more traction than expected. This show of indecisiveness resulted in earning the unflattering label of an “unreliable boyfriend” by a Member of Parliament. However, hindsight often cures many ills and now it seems Carney was right to hesitate. The BoE’s Chief Economist Andrew Haldane told the press last month he was “gloomier” about the U.K.’s economic outlook.

The U.K.’s European Conundrum

In any event, U.K. fundamentals continue to support a rate hike next year with some concerns. The British construction purchasing managers’ index softened in September, slipping to 61.4 points from 64.2. This was less than the 63.5 expected by economists. U.K. mortgage approvals fell to a 14-month low, but given the BoE continues to tighten access to mortgages to avoid a housing bubble, this was intentional. Employment continues to strengthen as “workless” households fell to a low not seen since 1996. And the U.K.’s gross domestic product rose by 0.7% in the third quarter, in line with market expectations, but lower than the 0.9% increase achieved in the second quarter.

When the BoE released the minutes of its last policy meeting, it maintained interest rates at 0.50%. But the minutes also pointed to dissension among the Monetary Policy Committee’s (MPC) nine members, as two of them favored hiking to 0.75%. Otherwise, the MPC voted unanimously to maintain the bank’s quantitative easing (QE) program at £375 billion per month.

The good news is the U.K. economy continues to recover at a steady pace. There are still challenges ahead including next year’s federal election that could upset the balance of power in London and potentially threaten the U.K.’s continuing E.U. membership. If, under a new government, the U.K. opts to leave the E.U. it could produce an ugly result. After all, the E.U. has sent a large budget bill to the U.K. There is an extra £1.7 billion that needs to be paid, and this week the E.U. made clear it will impose a fine of 2.5% of the debt (£42 million) on the U.K. if it fails to settle up by December 1.

Meantime, the EUR/USD pair continues to retreat as doubts continue to grow over the ECB’s options to help the eurozone economy crawl out of the deflationary trap it is in. The strong figures posted by the U.S. economy have boosted the USD versus the EUR. The Federal Reserve’s decision to end its QE program signaled the possibility of higher rates being introduced in the U.S. is but a question of time.

The ECB has been forced to seek alternative measures to stimulate the euro bloc’s economy. Germany is the biggest opponent of using more traditional monetary policy tools such as sovereign bond-buying. Chancellor Angela Merkel is unflinching in her austerity stance. She told German lawmakers last month that her government will not commit to raising public spending to stimulate the eurozone economy despite forecasting lower growth this year and next.

European Needs Meet German Demands

European leaders understand the message sent by the ECB. Reform and orchestrated efforts are needed to avoid a deflationary trap. That being said, the actual changes needed will not be popular with voters, and still have a large margin of error in an uncertain global economy. Merkel has not wavered in her negative view of borrowing to invest in a possible recovery. She chooses to concentrate in the positives in Europe, like the bailout debt payments from Ireland, Greece, and Portugal.

Tomorrow, European central bankers will challenge ECB chief Mario Draghi for what some critics view as his secretive management style. In other nations, it would have been called forward guidance, but in the quagmire that is the E.U., speaking out of turn could rapidly turn into a bigger political incident.

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