ECB: A Gathering QE Taper Consensus

Published on October 13, 2017
SGH Insight
Specifically, our sense is that two options under consideration would be a taper of purchases from 60 down to 40 billion Euros a month, for six months, or down to 30 billion Euros for nine months, with the latter far more likely to be adopted than the first. ECB officials can then take a lay of the land, and re-assess the Eurozone growth and inflation forecasts around the middle of next year to decide how to advance with the final leg of the program. Factoring in the reinvestments, the ECB is going to remain a significant player in the markets for some time.
Market Validation
(Bloomberg 10/26/17)

The euro fell back to a 1.1700 handle vs the dollar and was lower against a majority of its G-10 peers after the ECB unveiled plans to extend its asset purchase plan until at least September 2018 at a pace of EU30b per month. EUR fell to the lowest since Oct. 6 at 1.1707 after Draghi’s press conference ended, extending losses that began after the decision was announced.

euro daily chart

President Mario Draghi and his colleagues in the Governing Council of the European Central Bank appear ready to adjust the contours of their Asset Purchase Program at the upcoming monetary policy meeting on October 26, even if final decisions on some “modalities” of the program still drift into the next meeting on December 14. The current scheduled purchase program of 60 billion euros of bonds per month, of course, runs out at the end of this year.

*** Bundesbank President Jens Weidman and some hawks still favor a taper program with a firm endpoint to zero net new purchases next year. But with inflation, despite robust growth, still not “convincingly” where it needs to be, our understanding is that a strong consensus could be built with a compromise proposal to cut purchases by a greater amount, but over a longer period of time, than originally envisioned, and leaving the program end date open-ended, as floated by Chief Economist and ECB Board Member Peter Praet. ***

*** ECB officials will, and should, stress that the deeper cut in monthly bond purchases will be offset by a significant increase next year in the reinvestment of maturing bonds. These reinvestments jump from low single digit billions last year to as high as private sector estimated averages of around 15 billion Euros per month through 2018, and will grow even larger over time. The “lower for longer” construct also has an important additional benefit in alleviating concerns over the rapidly approaching problem of the scarcity of bonds available for purchase under the ECB’s self-imposed restrictions. ***

*** Specifically, our sense is that two options under consideration would be a taper of purchases from 60 down to 40 billion Euros a month, for six months, or down to 30 billion Euros for nine months, with the latter far more likely to be adopted than the first. ECB officials can then take a lay of the land, and re-assess the Eurozone growth and inflation forecasts around the middle of next year to decide how to advance with the final leg of the program. ***

Factoring in the reinvestments, the ECB is going to remain a significant player in the markets for some time.

Separately, the ECB as SSM bank regulator, has introduced strong guidelines to financial institutions for writing off Non Performing Loans. While this has caused a stir with the European Commission and in Italy, these guidelines should be very constructive in averting any more “warehousing” of bad loans on Eurozone bank books in the future.

Studying the Options

Technical considerations will never be the primary driver to ECB monetary policy decisions including how much and for how long to buy bonds. But with what is essentially an unanimity of view that the time is here to adjust those purchases down, the Guardian Council now has the luxury to focus on structuring a new a program that adequately factors upcoming limitations on the supply of sovereign bonds available to buy.

Of course, in case of emergency, the ECB can always extend asset purchases to other asset classes, such as equities, scrap for some more supranational bonds, and so on. But there is certainly every intention to avoid putting the institution unnecessarily in a position where it would have to consider those options.

Furthermore, the dynamics of keeping purchases under the ECB’s self-imposed, 33% limit of issuance and overall public supply become significantly more strained when the reinvestments kick in for real next year. And ECB officials have made it clear that with no end in sight to Bavarian lawsuits and criticism galore, that 33%,and the capital key guidelines allocating purchases between states, are not to be messed with at all.

All this argues for lower purchases, with the trade-off in length of time.

A Strong NPL Banking Regime

Meanwhile the ECB is taking strong and positive steps to ensure a sound banking system, even if in the process they have bent a few noses out of joint in Brussels, and in Rome.

Last week the ECB published guidelines to Eurozone banks for the treatment of Non-Performing Loans (going forward, for new NPL only). In it, they proposed that a loan in default for two years be written down, in full.  If a financial institution were to decide to still keep it on its books and then sell it for higher than scratch, they can then book that as profit.

If this may seem tough, it is. The aim is to reduce NPLs more forcefully, and ECB officials feel with strong growth and limited financial sector risk, now is the time. With a strong economy, banks can withstand write-downs better, and can perhaps get better prices for NPLs they choose to discard. They point out that this is how many non-financial companies basically do it, and so why not the banks? Furthermore, there is a clear need to harmonize and make intervention easier across the Eurozone.

But the ECB has met resistance on two fronts.

One is related to the timing of the rollout, and it devolved into a bit of a spat overcompetencies and mandates and such. The ECB appears to have politically jumped the gun a bit, and gone ahead of a study expected to be published by the European Commission on the subject and common PPP private public partnership guidelines for asset management companies.

There is, however, no question the ECB has a clear mandate over this, and any other, issue pertaining to the health and soundness of the banking sector through its SSM (Single Supervisory Mechanism), adopted by the European Union.

The more important source of resistance has been by and large out of Italy, both on the national level, and through Italian delegates who lobbied the European Parliament in Brussels to take a more adversarial stance on the issue.

Finance Minister Carlo Padoan has been especially loud in claiming that the ECB guidelines will harm Italy’s economy, and in a recent Brussels meeting, major Italian banks insisted the issue of NPLs is already well under control, and will be solved through higher growth.

Within the European Parliament, it was largely the Italian delegates that intervened after ECB announcement to fire a letter of protest off to Draghi

While easier in the short term, warehousing NPLs, ECB officials stress, are only a drag to the affected economies if held for too long. A case in point can be made in Greece, and in Italy itself, with the sale of NPLs by Unicredit Bank.

When all said and done those NPLs were sold low, at an effective 9% or so with all costs considered. But that allowed Unicredit to subsequently to go to markets for a capital raise, and with some success

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