ECB: Taking Stock of Ammunition

Published on February 11, 2019
SGH Insight
The ECB will need to clarify a new liquidity program for banks by June, but the discussion over whether to proceed with another round of long-term operations will probably not be settled by the March meeting, despite suggestions from Banque de France Governor François Villeroy de Galhau and a small minority of others that it may be in order. For one, the ECB will wish to assess the macro economic environment and especially the fallout from Brexit negotiations that appear to have wreaked havoc on German investment activity. Second, there appears to be a general desire – if possible – to wean banks from reliance on long term funding to the previous Fixed Rate Full Allotment system.
Market Validation
(Bloomberg 2/20/19)
Italian bonds decline and Bunds rise as ECB’s Peter Praet says TLTROs will be discussed soon, even though it’s unclear yet whether a decision will be taken.
BTPs bear flatten and FTSE MIB falls, underperforming euro-area peers, led by the banking index
10-year yield spread to Germany widens 6bps to 274bps
Bunds pare gains as Bobl auction sees underbidding of 1c even as demand increases to 1.6x from 1.2x prior
German 10y yield -1bp to 0.10%; March Bund futures +17 ticks to 166.59; France 10y -1bp to 0.52%; Italy 10y +5bps to 2.84%

At the last meeting of the European Central Bank Governing Council on January 24, President Mario Draghi emphasized in no uncertain terms that the Council had deliberated at length, and unanimously determined there were significant downside risks now surrounding the Eurozone economy.

But the ECB’s policy options beyond emphasizing the downside risks are limited and may need to be kept in reserve for later deployment should these risks – both internal and external – materialize further.

*** For now, markets are doing double the lift for the ECB, both in pushing out rate hikes and in flattening the yield curve, and ECB officials have had no issue in validating these very dovish market expectations. So while the time contingent element of the ECB’s guidance on liftoff and rates — on hold “at least through the summer of 2019” — will need to change as the summer approaches, there is little need for any change in March, at least as things currently stand. ***

*** The ECB will need to clarify a new liquidity program for banks by June, but the discussion over whether to proceed with another round of long-term operations will probably not be settled by the March meeting, despite suggestions from Banque de France Governor François Villeroy de Galhau and a small minority of others that it may be in order. For one, the ECB will wish to assess the macro economic environment and especially the fallout from Brexit negotiations that appear to have wreaked havoc on German investment activity. Second, there appears to be a general desire – if possible – to wean banks from reliance on long term funding to the previous Fixed Rate Full Allotment system. ***

*** Perhaps most intriguingly, ECB officials appear open to at least considering the Swiss and Japanese models of tiering negative deposit rates to help those segments of the financial system most hurt by the tax of negative rates on deposits, a system they originally dismissed. Part of that openness appears to lie in concerns over the potential shifting cost/benefit to the banking system of leaving low rates in place for too long after five years and counting of negative rates. Any such decision, however, appears to be heavily weighted for now by concerns that even the consideration of a tweak to the depo rate will be interpreted simply as a hiking signal, without any of the nuance, and under the current weak economic conditions is thus premature. ***

In the meantime, Frankfurt will wait, and assess the fallout, and the potential lingering effects of China, President Trump’s auto tariff threats, and above all, Brexit.

Communicating to Markets

ECB officials, dovish or hawkish – and there are none who matter really pushing a hawkish agenda to speak of – have no objection whatsoever with the markets having eased conditions significantly for them already in pushing rate hike expectations from the autumn of 2019 deep into 2020, and in aggressively flattening the yield curve in the process (see SGH 1/18/19, “ECB: Addressing the Slowdown”).

Indeed, they are pleased that linking rates and the balance sheet policy to signaling that the ECB’s full reinvestment policy for maturing bonds will remain in place at least for as long as rates are on hold has in effect doubled the whammy of increasing dovish market expectations and served as an “automatic stabilizer” along the yield curve.

And so with markets doing much of the heavy lifting for them, ECB officials do not seem at this point to see much of a need to make changes to their guidance. That could come, however, by the April or June meetings if the current pledge to keep the -0.4% deposit rate unchanged “at least through the summer” should prove long in the tooth by then.

ECB officials will also emphasize that the current normalization process is not really a “normalization in policy stance,” i.e., a tightening, and with reinvestments running at roughly 15 billion Euros per month still, it is more a gradual rotation and “normalization of instruments” deployed by the central bank. The ECB’s easy monetary policy stance, in other words, is being “preserved.”

A case is further being made in Frankfurt, perhaps drawing on the lessons from the Federal Reserve and its balance sheet communication miscues, that QE proved most effective when countering the sharpest dislocation and distress in the economy and markets, and so its removal does and will not carry the equal and opposite effect when markets are functioning relatively smoothly.

Debate over LTROs and Bank Funding

There also appears, in the run-up to the March meeting, to be some lingering hesitation still around the ECB regarding the redeployment of an LTRO (Long Term Refinancing Operations), TLTRO, or VLTRO style liquidity program for a Eurozone banking system that will need clarity over its sourcing for the replenishment of expiring funding programs by around June. That is despite a couple of officials, including would-be Presidential candidates Villeroy and Olli Rehn having floated the possibility of a new TLTRO program at the December ECB meeting.

More broadly within the ECB, there is an open question as to whether there is a macro case to be made at this point for another long-term fixed rate allotment to banks when liquidity remains ample, and the ECB can reinstate its Fixed-Rate, Full-Allotment liquidity program. As opposed to the LTRO programs, the FRFA is only very short-term money, secured by collateral. But it is nevertheless full allotment of as much liquidity as needed.

If, as June approaches, the ECB were to decide to go ahead with a new LTRO, it will almost certainly differ from the most recent versions in that the rate will be variable, avoiding a subsidy to banks for when the ECB does finally hike, and it will be of more limited size. The idea, post crisis, is to have banks back on short term funding, and weaned off claiming or facing a “cliff effect” every time a long-term funding program rolls off.

Waiting on Brexit

At a minimum, the ECB will want to wait until the end of March to assess the fall-out from the Brexit negotiations, which have wreaked havoc not so much on consumer sentiment, but on business investment throughout the Eurozone, and most especially in Germany.

While impossible to assess the exact contribution of Brexit jitters to the collapsed German manufacturing numbers –- other factors include Volkswagen’s bungled handling of new emission rules, low water levels on the Rhine creating transportation bottlenecks, and a disastrously executed switch in the energy sector from nuclear to coal – Bundesbank officials are concerned that the production slowdown which started in the second half of last year and accelerated in the fourth quarter may continue well into the first half of 2019.

It has not gone unnoticed, for instance, that even as orders for the all-important German auto industry have rebounded from their lows, production has failed to follow suit.

On a more positive note, all eyes are turned now to the fiscal side, and the surplus in Germany, reported at 1.7% of GDP for 2018, but from what we understand more likely closer to 2%. And the chatter is that a new day could bring an easing of the Merkel government’s pursuit of a Schwarze Null, or black zero of balanced budgets, policy, and, hope beyond hope, perhaps as much as a 1% deficit to GDP fiscal tailwind from Berlin.

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