ECB: Bridge to a Major December Meeting

Published on October 18, 2016
SGH Insight
Finally, there are reports that the ECB will continue on a limited, as needed basis, to allow for some minor deviation from the strict “capital key” guidelines for bond purchases if needed, meaning if there is any particular scarcity in a sovereign bond at a given time. That is correct.

Market Validation
(Bloomberg 2/16/17)
Sharp Jump in Italian, Spanish Bonds on ECB Capital Key Comments 07:40
Italian and Spain 10-year yields drop around 5bps, with smaller drop in France, after ECB meeting minutes show “limited and temporary deviations” from the capital key “were possible and inevitable”.
• The gains in these countries are due to their larger overall outstanding debt, as deviations from capital key suggests the ECB may end up buying a more bonds from these countries
• Bonds rallied sharply, before paring some advances

The ECB would be delighted if there were no market reaction to their Governing Council meeting this week, which is in essence a bridge to a critical policy meeting on December 8.

That is when the ECB will make a decision on extending the bond purchase program beyond March 2017 and how to address the related technical issue of the potential scarcity of bonds available for purchase under the Asset Purchase Program (QE) program. There is a chance those decisions could slip to the January 19 meeting, but we do not think that likely.

*** In the meantime, we expect President Mario Draghi to stress the need for stability and time to implement the current bond purchase program in his post-meeting press conference this Thursday. That may calm some of the nervous speculation swirling around the talk of tapering the current bond purchase program when it ends in March 2017. Draghi’s challenge, however, will be in phrasing current discussions – without closing exactly that option. ***

*** To achieve that, we believe the ECB message will revolve around “maintaining” the current highly accommodative conditions beyond March 2017 when the current bond buying program runs out. However — and this is a critical point — the ECB will be assessing broad financial conditions in weighing how much policy accommodation will be needed to maintain monetary conditions at current levels. And that does not mean the central bank will necessarily have to keep its asset purchases at the present pace to achieve that goal. ***

*** And so we continue to believe the ECB is likely to begin tapering its bond purchase program after March 2017 (see SGH 10/5/16, “ECB: A Major Inflection Point”). Underlying that decision to taper will be a growing sense within the Governing Council of a shifting risk/reward balance in driving rates “ever lower” and in keeping rates too low for too long – not just at the short end but along the curve – assuming the economic outlook holds up as broadly expected. ***

That would mark a gradual but major policy shift, the bottom of the ECB’s easing cycle, and the start to a “long runway” to begin the removal of extraordinary monetary accommodation.

The Beginning of the End, or End of the Beginning?

If, as we expect, the ECB decides to begin tapering its purchases beyond March officials will assert that continuing asset purchases – even if at a slower pace than before – would still be maintaining highly accommodative monetary conditions, in essence the “stock” versus “flow” argument for QE.

The template for a policy decision to taper and its messaging is the Federal Reserve’s unveiling of its own taper in the second half of 2013…or at least without the summer’s “taper tantrum” that saw US yields spike, but rather the way in which the Fed managed its messaging in the smoother run-up to the December launch of the tapering program.

And one of the lessons ECB officials are drawing from the Fed’s own bumpy experience with introducing a taper of its open-ended large-scale asset program was the importance of a long runway in messaging the shift in policy and managing market expectations.

Resolving technical constraints surrounding the scarcity of safe assets and challenges to implementation of the current program will certainly also play into any such discussion and assessment of what pace to continue the current bond purchase program when it rolls off in March 2017.

But a decision to taper will first and foremost be driven by the ECB’s economic forecast and conditions, and not on technical imperatives.

On that note, ECB officials are feeling more confident that even while growth remains tepid and inflation still uncomfortably low, they may see enough of the long awaited stabilization in energy prices that will finally drive headline inflation back up towards their 2017 target without the need for yet another embarrassing revision to the downside.

And with a corporate bond purchase program that has only just started and that has already proven effective in driving credit for not just large corporations but Small and Medium Size Enterprises as well, ECB officials increasingly see little wisdom in piling on more and more sovereign purchases just for the sake of it.

In other words, with rates already so low, many ECB officials are starting to question the wisdom of purchasing more and more bonds with the goal of “volume, for the sake of volume.”

Enter the concept of maintaining accommodative financial conditions.

Banks, Pensions, and the Curve

Against this backdrop the ECB is also becoming increasingly sensitive to the potential damage to the broad financial sector and, by extension, the monetary transmission mechanism in pushing deeper into negative rates.

And that risk is seen not only in driving rates lower, but from here on in increasingly in keeping rates at unnaturally low levels for too long a period of time – a very important messaging shift indeed from the ECB.

Just as importantly, the concerns over the transmission mechanism are not just about bank profitability (there is always room for a little tightening up in the bloated banking sector anyway). They are also about pension funds, insurance companies, the asset management industry, retirement plans more broadly, and potentially even on consumer and saving psychology and behavior.

Practically speaking, that means a need to factor that risk/reward in assessing not just the negative deposit rate, but in assessing the impact of ultra-low rates all along the curve, including in the longer end.

Addressing the Scarcity Challenge

By December, the Governing Council will also have in hand the results of the committee tasked to review options for addressing the potential scarcity of bonds available for purchase when the current bond purchase program is extended beyond March 2017.

A decision to taper the pace of bond purchases, if taken, will clearly help dictate what measures the ECB may have to take to address the potential scarcity of bonds. But the main driver to that will be economic reasoning rather than technical concerns. Obviously a taper or even modest backup in yields, especially in the AAA and German paper, would clearly help alleviate that scarcity.

The ECB will have to take additional measures even if it tapers, and we continue to expect it to adopt a variety of measures to address the scarcity issue, starting with raising the self-imposed limit on bond purchases from 33% to perhaps 40% or higher for AAA bonds.

In addition, we expect the ECB to authorize the purchase of bonds below the deposit rate, currently at -0.4%.

But with what we understand to be a very limited appetite to drive rates ever lower from here, we expect that loosening to come on a restricted, limited basis (we are not sure how). Again, the goal will be to make technical adjustments that on a macro level will be to maintain the policy accommodation levels.

Finally, there are reports that the ECB will continue on a limited, as needed basis, to allow for some minor deviation from the strict “capital key” guidelines for bond purchases if needed, meaning if there is any particular scarcity in a sovereign bond at a given time. That is correct.

There is still not, however, any consensus or even a real internal push, for a wholesale switch over from the ECB capital key to a market-based measure of bond purchases that would institutionalize a dramatic shift, mainly from German Bunds to Italian BTPs.

Officials point out that the ECB has been applying limited flexibility to the capital key guidelines already as needed, and often for different reasons.

For example, they have not bought bonds from Cyprus or Greece, and at the other end of the credit spectrum, have already had to forego purchases of Estonian bonds as theoretically required under capital key measures due to the simple lack of availability.

The ECB has also on occasion executed its purchase of Portuguese bonds at levels not strictly in accordance with the capital key measures. But this has not been driven by concerns over an imminent change in the DBRS rating for Portugal to below investment grade as speculated by markets, but again, for technical reasons under the current capital key program.

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