Reminders by senior European Central Bank officials that before resorting to any unconventional policy measures they do still have the option of a conventional mini-refi rate cut should they find the need to ease policy further have raised expectations that the Governing Council could ease again at either its upcoming monthly February policy meeting or more likely in March, when it completes its new quarterly staff macroeconomic projections. These expectations have been further fueled by another month of weak Eurozone inflation data, coupled with a certain degree of volatility in short term money-market rates.
Specifically, many analysts are now predicting that the ECB will shave 10 or 15 basis points off of its 25 basis point refi rate, and concurrently even drop its deposit rate from zero into very tentative negative territory – generally penciled in at -0.10%. In addition, President Mario Draghi has revived some “QE type” speculation over a new potential ECB bond purchase program through comments picked up at last weekend’s World Economic Forum in Davos.
*** We believe these expectations are off the mark, and for one assign a negligible chance that the ECB cuts rates at the February meeting. We furthermore assign low probability of any action even in March, as things stand, under the assumption that there will be no reason or evidence enough to trigger a significant downward revision to the ECB inflation forecast by then to justify another rate move. Some of the inflation based speculation about ECB rate cuts clearly misunderstand the extent to which the ECB has already penciled in a low inflation scenario, one that may take more than another month of lackluster data to abandon. In fact, there have been suggestions that the next forecast round could even show a slight improvement on the growth outlook, if anything. ***
*** ECB officials have of course also pointed to an unwarranted tightening in money market conditions against their forward policy guidance as a potential trigger for further easing. But here as well, while there has been some volatility recently in extremely short date EONIA rates, the all-important long term market structure and expectations of low rates remain well anchored, reflecting both an acceptance of the ECB’s forward guidance on low rates as well as the lackluster inflationary data that overwhelms what have in fact been some modest upwards growth forecast revisions, from Germany to Spain. A small cut in the refi rate that many analysts are now predicting could serve to cap some of this short term volatility, but the rationale or momentum for that most certainly does not appear to be in place for the next meeting, and we believe is unlikely to materialize even by March unless we see sustained movement or spread into levels beyond the overnight rate into the 3 month and even more importantly, longer term expectations. We would expect, incidentally, that even if a tweak in the refi rate were to come, it would not necessarily be accompanied with a cut in the deposit rates to below zero. ***
*** Finally, on non-conventional measures, Draghi did raise some eyebrows in comments last week by mentioning the option of the ECB purchasing packages of loans from Eurozone banks. We do think it interesting that this option is being revived in public, but it continues to be a hypothetical move that still faces enormous challenges in implementation, and in fact is a repeat of the discussions last year on the purchase of ABS packaged SME loans that essentially went nowhere. In reality, like the covered bond program, if the ECB were to build it, as Draghi maintains, “the markets may come,” and revive the moribund ABS market. But even in a best case scenario these purchases would amount to a limited program in the tens of billions of Euros, as opposed to the hundreds of billions (and trillions) of QE purchases resulting, for example, from a Fed-style QE program. ***
Keeping an Eye Open, Just in Case
Of course the ECB has gone to lengths to assure that it does take its inflation mandate seriously – on the downside as well as the upside – and we take assurances that they will act to protect that mandate, and market stability, if needed to heart (see SGH 12/3/13, “ECB: Weighing Future Actions”). But importantly, Governing Council members have also recently pointedly asserted that a good portion of the non-food and energy related deflationary pressures experienced in parts of the Eurozone stem from a lagged effect of the fiscal adjustments in program countries (Spain, Greece, Ireland and Portugal).
If that downside pressure accelerates, or if it results into a more extended, and dangerous, period of sub-par inflation than expected that pulls the all- important long term inflationary expectations down with it as well, the ECB will of course respond. But the implication for now is that the current ultra-low inflation readings continue to reflect a necessary, and most importantly, what is still expected to be a transitory phenomenon.
On money market rates, medium and long term pricing expectations are, and we expect will remain, far more important indicators of financial market tightness than any minor fluctuations in the extreme front end of the market in response to short term liquidity shifts.
While the very short end has certainly exhibited a degree of volatility that has caught the markets’ and policy makers’ attention, part of this is being ascribed to the desire by banks to end 2013 showing a strong liquidity position on the balance sheets. Not that there is any gaming of the system, of course, but from what we understand much of the Asset Quality Review (AQR) exercise will be based on the snapshot of the banks’ balance sheets as of Dec. 31, 2013. This is believed to have driven the end of year price of liquidity higher than in normal year-end closings.
Of course the repayment of VLTRO funds is also helping push short term rates up, but here as well, ECB officials have for some time downplayed the focus on Eurozone excess liquidity levels unless there is evidence of broader spill over into medium and longer term rates – and most definitely abandoned the old 200 billion Euro “threshold” of expected sensitivity of markets to excess liquidity. That “threshold” in and of itself has gone the way of the Fed’s 6.5% unemployment threshold and the Dodo bird (to be followed soon we expect by the BOE effective abandonment of its 7% unemployment rate threshold).
For some context, while overnight money has fluctuated rather wildly from 45 to 10 to 36 and now back to 18 basis points, three month EONIA rates have fluctuated from around 10-12 to 20 and now back to 18 basis points, and 1 year EONIA rates have essentially been range bound between 10 and 20 basis points. And beyond that, five year EONIA rates have actually fallen, from 1.2% to 0.7%, over the past four months.
Overnight rates are certainly an anchor to market stability, and not to be ignored, and as opposed to EONIA, 3 month Euribor, which includes some credit risk premium for banks, has crept up from 20-22 to about 30 basis points (with one year rates around 50-55 bps). But while yes, a refi cut could help cap some of the short term volatility, and the ECB will certainly keep an eye on – and continue to jawbone – its forward policy guidance in order to control rate expectations, the volatility of these moves for now are still muddied by year end and AQR factors, and we suspect there may indeed be little need to “correct” the actual level of market rates even by March as is now increasingly being anticipated.
Finally, and also critically related to both its assessment of monetary conditions as well as the geographic bias of current Eurozone inflationary trends, the ECB Governing Council has, and we expect will continue to, also positively factor in the recovery in bond markets and collapse in funding rates in the southern European countries, including Spain and Italy, as well as Portugal and Ireland.
On the heels of an incredible rally in Eurozone peripherals, these markets may experience a hiccup here and there, especially given some massive issuance in January and in light of the taper/EM market washout of recent days. But we nevertheless believe European peripheral spreads will continue to trade with little fear of the type of contagion that has gripped EM markets, and other than some recent wobbles with the Greek program, we continue to expect Portugal to follow Ireland and Spain and successfully come back to bond markets this year, with a little help perhaps of a credit line (see SGH 10/31/13, “Portugal: Avoiding Past Mistakes”). All this will help with the all-important “transmission mechanism” of low rates to the deflationary prone countries.
In case of a major downturn, we have written that most intriguingly the ECB has been quietly moving closer to the formerly taboo option of unsterilized purchases of bonds in the secondary market, a measure that is in fact permitted in its mandate but remains very controversial still among the hawkish countries. Recent comments by President Draghi that the ECB could purchase bundles of bank loans in the secondary market are a public reminder and acknowledgment of that possibility, albeit without addressing the far more powerful and legally controversial option of buying government bonds on the secondary markets without the conditionality of an OMT program.
Draghi himself has certainly proven to be willing to test the ECB limits, and to quietly nudge his fellow Board members into uncharted waters. But we would temper any interpretation of the latest comments by Draghi as any policy shift towards “QE” with a reminder that they actually reflect a much more limited revival of the long standing hypothetical discussions surrounding “SME” bundled bond purchases, an idea that while attractive has essentially gone nowhere, and is based on the development of a market that does not even exist yet in any size, with little consensus on its feasibility or success.
It could happen at some point, and its mention is interesting, and probably does reflect a delicate attempt to keep tip toeing the ECB towards considering how deeply it can go into unconventional territory – just in case there is a need at some point to “break the glass.” But that is a question for another time.