ECB: Reinforcing Forward Rate Guidance

Published on September 27, 2013

European Central Bank officials have been out in full force publicly flagging the possibility and willingness to consider another Long Term Refinancing Operation – if and when one might be needed.

There is little strain currently on European money markets and no sign of any strong demand from banks, which are in fact still slowly returning funds borrowed from the last LTRO. Markets are, correctly, assuming that this does not flag an imminent move at next week’s monthly Governing Council meeting of the ECB next Wednesday in Paris.

*** One option that does appear specifically to be under consideration, however, and again if and when needed, is a new and powerful twist on the previous LTROs, namely a three year fixed rate LTRO, with an embedded option for borrowing banks to re-set their loans at a lower rate if the ECB were to cut rates during the loan period. ***

*** LTROs are by definition demand-driven, and more limited in effectiveness for that reason than, for example, the Fed’s liquidity operations, which push liquidity into the system through security purchases. ECB officials are aware of this and that they would have very little take up if there is little demand for funds. But we believe this new form of LTRO would provide a very strong incentive for banks to borrow, and would in fact enhance the ECB’s promise to keep rates “low or lower,” by providing borrowers with both a long term fixed cap on higher rates (a put) as well as in effect a call option on lower rates. ***

*** As of now this LTRO talk appears to be, to some extent, verbal intervention to prevent any creep up in market rates and expectations. The willingness to provide a new LTRO is conditional and as such the mere talk of it certainly serves to help markets. But the fact of the matter is that there appears to be growing consensus across the ECB that if further action were to be needed to address tightening money market conditions, an LTRO would be the more likely response than a cut in the refi rate from 50 to 25 basis points. ***

The View on Refi Cuts

ECB officials are now fairly confident that a cut in the refi and a collapse in the corridor between the deposit and refi rate is technically feasible, and from what we understand a 25 basis points cut was in fact on the table at the July 4th ECB meeting where the ECB unveiled its forward guidance on low rates, as a way of reinforcing the forward promise.

In fact ECB President Mario Draghi was himself, we believe, sympathetic to a cut as an extremely effective way of managing market interest rates and reinforcing the forward low rate guidance message. Some other Governing Council members, however, were concerned about a potential unintended overly negative signaling on the economy an actual cut might provide to the general public and markets. So in the end, this option was dropped in favor of the compromise to add the words “or lower” to the promise of “low” rates going forward.

This signaling concern also appears to underlie the preference to deal with a potential market tightening down the road with an LTRO rather than a refi rate cut and narrowing of the corridor. While a cut later would in fact prove very effective in capping rates, it may still appear as incongruous with a broader message of a slow albeit tepid recover in the economy, whereas a “technical” response to a “technical” money market issue would appear more appropriate.

The If and When of an LTRO

As to when and under what condition the ECB may provide a new LTRO, there appear to be two general strands of concern that might trigger action.

The first is the possibility that the upcoming Asset Quality Review and Bank Stress Tests may create some tensions in markets. But the Stress Tests from what we understand are likely to be delayed yet again beyond current expectations and not to be completed until June or July of 2014.

But there is some concern still that backstops are not fully in place if there is the (unlikely) need for a recapitalization that would require not just sovereign, but pan European funds as well. Recapitalizations would, as it stands, currently need to follow the “Spanish model.” There is also some concern that the European Commission may be tempted to play hard ball and prove too quick to push for bail-ins if needed on some mid-size banks.

The second strand of potential concern is that European markets rates could prematurely drift up for reasons beyond the ECB’s control, not reflecting their fundamental outlook on the economy, and despite their forward guidance.

The Fed decision to hold off on tapering at the September meeting has provided the ECB with a bit of a “get out of jail free” card on externally driven rate creep. But ECB officials are still deeply cognizant of the problems they had in managing rates right after their initial forward guidance meeting when European markets sold off aggressively in step with the taper-led sell off in US rates.

One “trigger,” so to speak, for action that the ECB would like to move away from is the previously flagged historical tendency and risks of market rates moving higher if excess liquidity in the banking system drops below the 200 billion Euro level.

With extra liquidity already sitting more or less right at that 200 billion Euro marker and banks still returning funds to the ECB, there appears to be little or no signs of a back-up in market rates, and ECB officials certainly do not want to send the signal of a “trigger” that does not exist. Draghi pushed back a little on this at the last press conference but there is likely to be more clarifications of this “200” threshold coming.

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