ECB: A Major Inflection Point

Published on October 5, 2016

The European Central Bank will absolutely not tinker with the existing Asset Purchase Program (QE) bond purchase program before its scheduled expiration in March 2017. Eurozone services inflation is, if anything, losing a bit of momentum, and hitting the ECB’s inflation forecasts for 1.2% in 2017 and 1.6% in 2018 are predicated on concluding the current APP program. It also assumes an extended period of extremely accommodative monetary policy for the policy forecast horizon period beyond.

*** There is , however, a subtle but extremely significant shift within the ECB Governing Council – among both doves and hawks alike – in reassessing the cost/benefit trade-off at both in the short and long end of the yield curve in driving rates “ever lower” from here. Barring any unlikely economic surprises, the objective for the Governing Council in December will thus be to maintain, not increase or decrease, the level of accommodation in the system after March next year. ***

*** There is therefore a good chance the APP will be extended beyond March 2017 at either a lower monthly purchase level from the current 80 billion Euro pace, for example at 60 billion Euros for another six months, or perhaps tapered steadily lower at a gradual monthly pace. The ECB is also likely to revisit at some point soon its communication to date that rates will remain “low or lower” (emphasis added) for the foreseeable future. And like the Federal Reserve, the ECB will not move on rates until well after tapering bond purchases. ***

*** In their assessment of the level of bond purchases required to maintain desired degree of accommodation, ECB officials will be weighing a broad range of financial market condition measures. Those will include, for example, funding and credit availability, equity levels, Fed policy, and the Euro. The ECB’s assessment of its monetary policy will also include expectations for some modest fiscal tailwinds for the Eurozone in 2017 that could finally take some of the pressure for stimulus off the ECB alone. ***

While a “hawkish” ECB may at first blush appear negative for markets, a tolerance for stable or even slightly higher market rates, if appropriate for the economy, actually reflects a growing sensitivity towards the negative impact ultra-low rates for a very extended period are having on the banking sector, insurance and pension funds, and even perhaps on inflation expectations in the long run as well.

Accommodation with Fiscal Stimulus

Barring any unlikely economic surprises, the ECB’s policy objective will be to maintain the level of accommodation in the system, not increase or decrease it, after March 2017 when the current APP program runs out.

The exact monetary policy contours of how best to achieve that will not be finalized until at the December 8 ECB Governing Council meeting, when the ECB will have both its quarterly economic forecast revisions in hand, as well as the technical study completed weighing options for addressing the potential scarcity of bonds available for purchase.

Importantly, ECB officials are now looking at a broad measure of financial market conditions, including funding and credit availability and equity levels, to make the assessment of what sort of rollover program for bond purchases will be required to maintain accommodative levels.

That decision will be driven by their assessment of other exogenous factors as well that could help complement ECB monetary policy, including expectations for some fiscal stimulus tailwinds out of the Eurozone. That just might, finally, allow monetary policy to carry something other than the entire burden of stimulus for the Eurozone economy.

That fiscal spending will not just come from the noisy and highly politicized (and somewhat theatrical) battles between Brussels and Italy’s Prime Minister Matteo Renzi for additional spending, and the rather meager prospects for the clearly disappointing pan-European “Juncker Plan.”

They will also include a much more significant 0.5% of GDP in additional spending from Germany – with no offset – that is now being forecast by the Bundesbank for 2017 as needed to pay for the massive influx of migrants into the country.

While this fiscal bump is forecast to taper down beyond 2017 as the flow of migrants peaks out, it will be enough in 2017 to almost completely wipe out Germany’s current 0.6% of GDP fiscal surplus.

The Fed Factor and the Euro

Before finalizing its assessment of monetary conditions  at its December meeting, the ECB will also take measure of global conditions, including the forecast for the Euro and what is likely to be Fed rate hike a week after the December meeting.

A soft Euro has helped the Eurozone offset headwinds to its export sector, resulting mainly from softness in global EM economies and markets. And ECB officials appear relatively non-plussed and if anything pleased with the current level and stability of the currency against the dollar, and the lack of volatility of currency markets in response to expectations of a possible Fed hike.

Indeed, there appears to be no real desire or urgency to drive the Euro lower from here (and certainly not higher), and ECB officials point out that a much stronger dollar that hits the US would not in the end benefit anyone in the global economy.

They furthermore point out that the decision by the ever gradualist Fed to pause in September in favor of a December hike benefited the Eurozone in that even while the Euro remained stable against the dollar, EM currencies strengthened — meaning the Euro weakened — on the much more important trade-weighted basis against a global index.

And that, at least until recently, has helped the Eurozone “digest” the sharp appreciation of the Euro against the collapsing British Pound Sterling, which does have a major impact on the Eurozone.

Bunds and Scarce Assets

ECB officials are also increasingly sensitive to the impact its aggressive QE policy is having in exacerbating the scarcity of safe assets, mainly German and other ultra-high rated bonds, and they are supportive of efforts by the Bundesbank to alleviate some of those pressures through potential modifications to the tight repo market for Bunds.

Those modifications appear to include the possibility of the Bundesbank extending securities lending operations beyond the clearing house-based Clearstream Banking Luxembourg (CBL) Automated Securities Lending (ASL and ASL plus) programs, to bilateral repo operations.

A decision to shift purchases away from the ECB Capital Key to a Market Value or Size based approach would also clearly help alleviate this scarcity problem in shifting the bulk of ECB sovereign bond purchases way from German towards Italian paper.

But that shift still appears politically unfeasible, and the ECB is still likely to address the scarcity issue, if needed, in December by allowing purchases below the -0.4% deposit rate. That will however probably only be allowed on a limited basis in order not to drive rates ever lower.

That decision will also likely include the lifting of the self-imposed 33% cap on bond purchases, but only for AAA or similarly ultra-high rated paper, to the 40% level or so.

 

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