ECB: Delivering the Right Cocktail

Published on May 29, 2014

European Central Bank officials have done little, if anything, since last month’s policy setting meeting to push back on market expectations that they are highly likely to ease monetary policy at their upcoming June 5 Governing Council meeting.

Any cautionary note, from hawk or dove, has been more to remind markets that a cut is always dependent on data and never a foregone conclusion (of course), and that implementing the full cocktail of policy measures needed by the Eurozone in a timely fashion will be challenging.

*** We continue to expect the ECB next Thursday to lower the interest rate paid on deposits from zero into negative territory while cutting the refi rate by an equal amount from its current 25 basis points level (see SGH 5/8/14, “ECB: Negative Deposit Rates in June”). More specifically, we expect the entire official interest rate corridor to be lowered by 10, or even perhaps by 15 basis points, which would be more aggressive than market expectations (we are surprised that in a recent bank survey 30% of FX participants actually still expect no rate move at all). A cut will most likely also be accompanied by additional measures on the liquidity and macro-prudential side (more on that below). ***

*** Furthermore, we fully expect ECB President Mario Draghi to remind markets that beyond a rate cut, in case of a deeper or more protracted fall into dangerously low inflation territory, the ECB has at its disposal the additional weapon of large scale asset purchases, or QE – what we have referred to as the “two-step” policy approach. You will also recall from our reports that it was the ECB Board’s success in gaining “unanimous” consensus across the Council on the possibility of QE, and its subsequent ability to put that option in its back pocket if needed, that freed it up to use the last of its remaining “conventional” tools, with a dabble into the unconventional territory of negative deposit rates. ***

To be clear, the ECB will not announce or embark on a QE program (meaning sovereign bond purchases as opposed to the more limited ABS purchases) at this meeting. It is the availability of that option down the road if needed that ECB officials hope will give an additional boost to the counter-deflationary impact of their rate cuts next week.

The Full Package under Consideration

After months of subpar inflation readings, and with another staff quarterly forecast revision due at next week’s meeting that will be sure to tweak already anemic expectations even further down, we believe the interim Eurozone May CPI due on June 3 report would have to be shockingly stronger than the consensus 0.7% to put a rate cut into question, if even then.

ECB officials are well aware that messaging the willingness to ease even further if needed will be critical to the success of this new phase of communicating a “ready to do anything within our mandate that is needed” deflation prevention message; in effect, the ECB is hoping for a success similar to the OMT message that so strongly committed the ECB to prevent a Eurozone breakup. And in this case, in addition to the potential for large scale asset purchases, that possibility of still further easing could also mean saving a little more room for potential further action on the rate cut side.

ECB officials agree that there is a practical limit to how far a central bank can cut into negative territory without creating distortionary and negative consequences – such as cash hoarding or banks passing on the deposit tax to consumers through higher fees. We have heard estimates of that limit to be around -0.25% or so.

To make the point of going negative on rates but with the option of still another small cut if needed, we understand the ECB is more likely than not to stick with a cut this time around to -0.10%, although we do not rule out a more aggressive move to -0.15%.

There are in addition lingering concerns still across the ECB that even a limited negative deposit rate could be seen as a “tax” that leads to an unintended negative retrenchment and response from the banking system, and so a cut is very likely to be accompanied by an offsetting measure to ensure liquidity.

That is likely to be either through another bank LTRO (Long-Term Refinancing Operation) or adding liquidity by ceasing the sterilization of the ECB’s approximately 170 billion Euro SMP bond portfolio.

We do not have a strong sense for which way the ECB is leaning on these two options except that the LTRO would be a more durable measure, whereas the SMP, while more limited in size, is a lower hanging fruit. It is noteworthy as well that the ECB has for the past few weeks struggled to sterilize the full SMP portfolio amount. The SMP option could also psychologically drive home the ECB’s willingness not to sterilize future bond purchases with a QE program – a signal the ECB was previously unwilling to give before reaching consensus on the possibility of QE.

The ECB has also looked into macro-prudential measures to counter any potential contractionary effects of negative rates, and to encourage any new LTRO-supplied loans to banks to find their way into the economy rather than pool deeply again into bank-sovereign bond carry trades.

Ideas include tying LTRO lending rates to specific bank balance sheet ratios, or accompanying negative deposit rates with a cap on current account excess balances to keep banks from simply avoiding the negative deposit rate at the central bank by piling up current account excess reserves.

The ECB has for months also studied options for stimulating the Eurozone’s small Asset Backed Securities (ABS) market, specifically when it comes to securitizing loans to SME (Small and Medium Enterprises), and the potential purchase of these limited ABS securities has at times been conflated with QE.

We do expect the ECB to continue in its efforts to stimulate that market, specifically in fostering a higher credit tier ABS that will be easier to securitize. But this continues to be a long-term project, and the more immediate focus with ABS is still on easing regulatory and capital requirements to make it easier for institutional investors to hold these securities.

Negative Rates, Bonds, and the Euro

If truth be told, ECB officials do not harbor any illusions about the effectiveness or direct transmission impact of a small cut in rates into higher bank lending. They are well aware that their challenge lies more broadly in reversing dangerously low inflation expectations and stimulating confidence across the Eurozone in a resumption of both growth and inflation back to its target. And that will require not just one move, but a consistent and credible message of policy support to do “whatever it takes (within its mandate)” to that effect.

On an immediate level, a negative deposit rate will of course lower the carry for holding the Euro and help reinforce the rate differential between the US and Europe that ECB officials believe more fundamentally reflects their different positions on the economic cycle – or in plain English, weaken the Euro (see again SGH 5/8/14, “ECB: Negative Deposit Rates in June”). We are not implying that the ECB explicitly targets a lower Euro per se, of course.

The ECB has been satisfied with its ability to manage forward guidance for the Eurozone, but with inflation continuing to persist at such dangerously low levels, it has grown increasingly sensitive to the market’s inability to reflect that in the Euro – be it due to current account inflows into the Euro, temporary safe haven flows from Russia during the Ukraine crisis, or a growing impatience with the pace of the US economic and rates recovery — not that anyone wants another “taper tantrum” and bond market meltdown.

So the ECB has decided to take the additional step to reinforce that differential with action of its own, and in a communication that there will be more where that came from, if needed. Of course, given the size of European markets, a dovish ECB willing to push more Euros into the market can and has spilled over into boosting a US bond market that is already supported by a benign Fed, tame inflation, and soft data. And that “leakage” to some effect has ironically helped offset and dampen some of the direct impact on the Euro.

But we do expect actual delivery by the ECB on rates and a stabilization of US data and currently overly pessimistic expectations on US growth to help keep the wind in the Euro weakness trade. And in the meantime it is certainly nice to have the ECB share some liquidity with the rest of the world.

As a note of caution, Draghi will next week have to balance that message of readiness to do more if needed with a desire to remove any premature or unwarranted expectations for immediate action to follow next week’s decision. The ECB will ideally want to wait another few months for implementing and gauging the impact of these measures before moving, if needed, and the hope of course is that this month’s actions may negate the need for further moves.

Revising the central bank’s meeting schedule from every month to every six weeks, a wise move in our view, (quarterly would be far too infrequent), would certainly help lower that constant pressure and noise.

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