ECB: Gut Check

Published on September 3, 2014
SGH Insight
"We suspect there is at least a reasonable chance the ECB could add a small rate cut tomorrow to the much anticipated roll out of its ABS program. While of limited effectiveness as a stand-alone measure, and thus not widely expected, a small rate cut alongside other measures could help generate greater interest in the upcoming TLTRO as well as keep pressure on the Euro in further reinforcing the Eurozone rate differential story."
Market Validation
(WSJ 09/4/14) "In an effort to keep too-low inflation from derailing the eurozone's weak economy, the European Central Bank surprised financial markets with a cut in interest rates and new stimulus plans, despite opposition from Germany's powerful central bank."

There has been little in the way of public commentary on monetary policy from European Central Bank officials since President Mario Draghi spoke on August 22 at Jackson Hole.

That is at least in part because so soon after returning from the end of the summer holidays, most ECB officials were perhaps seeking the refuge of the pre-meeting purdah before further comment, preferring instead to assess the ECB’s policy options in the face of the falling growth and inflation across the European landscape around them.

High on the agenda is redefining the consensus on the commitment, as expressed by Draghi, to “do more, as needed.” But we do not believe there have been any substantial policy shifts being advanced going into the meeting beyond what we wrote on the ECB on the eve of the Jackson Hole meeting (see SGH Report 8/21/14, “Draghi in Jackson”).

*** If there is any movement beyond that, we suspect there is at least a reasonable chance the ECB could add a small rate cut tomorrow to the much anticipated roll out of its ABS program. While of limited effectiveness as a stand-alone measure, and thus not widely expected, a small rate cut alongside other measures could help generate greater interest in the upcoming TLTRO as well as keep pressure on the Euro in further reinforcing the Eurozone rate differential story. And we expect the ECB to make a commitment to purchasing high quality ABS securities, advancing that project further. But that remains more of a longer term initiative, and is likely to be limited in its impact for some time, except in so far as being seen as a stepping stone to further, sovereign bond purchases. ***

*** In terms of the high pitched volume on QE expectations, we still think the ECB is in fact very seriously weighing its launch, despite a healthy degree of market skepticism right up to Draghi’s Jackson Hole speech that the ECB would ever actually pull, or be allowed to pull, that trigger. While still politically controversial, the debate over sovereign purchases has long moved from one of whether it is in fact permitted under the ECB mandate to a question of its effectiveness, moral hazard, and timing. But that is an emergency measure that still remains for later, rather than now. ***

A Rate Tweak among the Options

Most ECB watchers and economists feel that a cut in the order of magnitude of 10 basis points could be seen as too small, as too much tinkering, or as going against Draghi’s own assertions last June that the ECB was effectively at or near the bottom of its rate cut options.

We suspect, however, there may be a willingness now to throw a rate “adjustment” into the mix along with other measures to reinforce the ECB’s  willingness to push the envelope and do all that is needed – conventional and unconventional – to bring inflation back to its 2% medium range target.

For context, our understanding is that the effective limit for negative deposit rates has been thought to be roughly in the area of -0.25% or so, before negative rates start to create distortions such as an incentive for cash hoarding instead of keeping money in the banking system. So in theory there is some small room to lower the refi rate (currently 0.15%) and deposit rate (currently -0.10%) a touch further. This “limit” is of course to some extent largely guesswork as it is all uncharted territory.

But another cut would make the upcoming, variable rate TLTRO facility even more attractive, which in itself makes the small rate adjustment worth weighing; and it would certainly continue to reinforce the rate differential story with the US and rest of the world and keep pressure on the Euro.

One easing option that has been floated by economists, but that we think is less likely, is for the ECB to remove the 10 basis point spread it decided to charge for TLTRO loans over the refi in order to make the facility even more attractive.

While possible, we believe that could be seen as an incongruous, rather limited fine tuning of a credit spread in response to major disinflationary pressures, and a measure that would only in effect be helping the banks taking out TRLTO loans.

The ABS Program

As we noted in the August report on the ECB (SGH 8/21/14, ECB: Draghi in Jackson”), the ECB will also want to see how measures taken in June feed through the economy, but it has also promised to deliver “something” on the ABS purchases. We have been expecting them to announce some progress on the initiative to develop that market, intended to lubricate the transmission mechanism of cheap financing to the real economy, at this meeting.

Since last month’s Governing Council meeting, the ECB announced the retention of Blackrock as the consultant on this project, and we still expect they may announce an agreement tomorrow to buy those higher rated ABS issues at relatively attractive haircuts – if and when banks package them. The ECB has also been leaning heavily on both industry-wide and national authorities to ease regulatory guidelines and requirements around holding these securities.

ECB officials have of course been talking about ABS stimulus forever – and we have been writing on it for even longer – and it is if anything a long term project with limited near term impact due to the small size of the market.

But the current market mood is to give the benefit of the doubt to the ECB for taking any additional steps. So any definitive announcement by the ECB tomorrow it indeed stands ready to purchase these ABS securities — which some analysts are now even referring to as “private sector QE” — will not be taken as a disappointment. If anything, in this environment, it will be taken instead as a sign of the ECB’s commitment, and even as a marker put down for delivering “soon” on buying sovereign bonds (the real QE), and potentially other types of securities.

That is especially so given that so many market participants still were of the belief that the ECB (or Berlin) would never in reality ever allow for sovereign bond purchase QE program, and they have only just started to waken to this as a real possibility.

Further Clarification in the QE debate

We have, of course, been writing since soon after the turn of the year (see SGH 2/18/14, “ECB: Signaling the QE Option”) that the ECB Executive Board has been whittling away at the resistance to QE by the Governing Council’s institutional hawks, most notably the Bundesbank.

For all the political complications of a sovereign bond purchase program, there is a wide consensus within the Council in fact to the principle that, if the economy were to really turn south, the ECB could indeed launch a sovereign QE program.

In fact, the resistance to QE turned some while ago from questions of whether or not it was within the ECB mandate, to questions of effectiveness, moral hazard, and timing.

And on the political side, while QE is certainly not a popular strategy in Germany, it would not necessarily require Bundestag approval, even though that may politically be preferable, as it is not a disbursement per se from the German budget (as the ESM was), but an expansion of the ECB balance sheet and within its monetary policy mandate.

That is not to say there would not be legal challenges aplenty if the ECB were to go down that route – that is almost a guarantee – but ECB action does not fall under Karlsruhe jurisdiction, and this crisis, as it has been with the Federal Reserve, has been one of the persistent testing of the limits to the ECB’s tools and mandate, as well as its political room for maneuver.

In fact, Berlin is eminently pragmatic, and we suspect would not stand in the way of a QE program if it were needed to salvage the Eurozone from the depths of a recessionary and disinflationary cycle, especially with growth even in Germany now faltering.

But we are pretty sure they are not there yet for a host of reasons, as outlined in our last report. That could yet change by the end of the year if the economy does not rebound, and Draghi will leave the door open to more if needed down the road.

Downward Pressure on the Euro

Draghi is almost certain to keep pointing to the rate and economic cycle differentials between the Eurozone and US and keeping European rate expectations anchored, as he has done in the past, in order to keep the pressure on the Euro.

He will also no doubt talk about the need for investment spending from Europe and good fiscal budgets that include tax cuts along with spending cuts, and not just tax hikes. But he will have to tread a bit more delicately on these “structural reforms” to emphasize he is not advocating a Krugman-inspired free-for-all abandonment of the Growth and Stability Pact, the 3% targets, and the German-imposed Fiscal Compact (after all, the “stars” of the recovery have been those countries which have undertaken their belt tightening “properly,” albeit at the cost of enormous lost output and soaring youth unemployment).

Rather, the ECB President will call for a sound makeup of measures within solid long term fiscal policy, focused on high multiple investments, fully using the flexibility already accorded in the EU treaties (and by an already far more lenient European Council and Commission). France and Italy will get ECB help, but they also need to help themselves to at least some degree on true structural reforms in the way Spain, Portugal, and Ireland already have.

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