ECB: Signaling the QE Option

Published on February 28, 2014

The Euro has rallied in a fierce short squeeze this morning to 2014 highs against the dollar on the back of the stronger than expected preliminary February Eurozone HICP inflation figures.

That those “stronger” numbers were a mere 0.8%, one tenth above expectations of 0.7%, and flat from the month before, are nevertheless telling as to how low those expectations have really fallen. Weak energy prices did, as the ECB has been expecting, exert a significant drag on the data – the core readings in fact nudged up a bit from 0.8% to 1.0%. But February represents the sixth month in a row of sub-1% inflation numbers between 0.7% and 0.9% at best.

And that is precisely the problem most concerning now to ECB officials.

*** ECB officials are increasingly alert to the risks in such a protracted period of dangerously low inflation. While the inflation numbers are clearly not outright deflationary yet, even if they do at least stabilize or creep up a tad as expected, the margin for error in an ability to absorb any negative drag is far too small for comfort. And while those all-important long term inflation expectations remain “anchored” at the ECB’s “below but close to 2%” target, that is being seen increasingly as a necessary but not sufficient anchor in and of itself. Expectations tend to remain anchored until they suddenly aren’t, and by then it is often too late to act with any real effectiveness. The consensus within the ECB is therefore building to ease further, even if on a purely “risk management” basis. ***

*** The ECB, traditionally, has been hesitant to take action for “insurance” purposes, but the first release of a 2016 forecast at the upcoming March 6 meeting will predict a fourth year of misses on its target. That there is nothing or little to lose in easing at this point will, despite today’s market reaction to numbers, keep the discussion for further action squarely on the table — including next week’s meeting. That could take the form of essentially capping short term rates even further through either a cut in the refi rate from 25 to 10 or 15 basis points, a halt to the sterilization of the 175 billion Euros of SMP bonds held in the ECB portfolio, which we have been flagging (see SGH 2/18/14, “ECB: Supporting Forecasts and Rate Guidance”), or both. ***

*** Most important of all, however, ECB officials are already seriously considering the option beyond those more limited measures down the line of the outright purchase of government bonds as a part of the full “360 degree” view of the toolkits they have been talking about. And here, markets may be far too focused on the 175 billion-Euro liquidity impact of a halt to SMP sterilization and missing the signal effect in the precedent that would be set for bond purchases were the ECB to stop sterilizing that bond portfolio. ***

Too Low for Comfort

The ECB in December forecast inflation to bump along at an anemic 1.1% this year and at a continued dangerously weak pace of 1.3% in 2015. We expect the first look into 2016 at the upcoming March Staff Economic Forecast to probably come in close to the Professional Survey forecast of 1.7%.

What would a “no-man’s land” sort of, say, 1.7% inflation forecast for 2016, mean to the ECB? While pointing to an eventual gradual improvement, that forecast would represent the fourth year of the ECB missing its target. The ECB would of course look at the causes, and some would question the wisdom of relying or taking action on the basis of forecasts within a few basis points here and there looking two years out.

And of course, some of this weakness has already to a large extent been factored in (see again SGH 1/28/14, “ECB: Needing More Evidence to Ease”). A good portion of the recent drop off is being attributed to a year on year base effect impact of energy prices that looks increasingly likely to, as expected, reverse itself in the second half of next year.

But there is also a certain degree of inertia to this inflation. With a 2014 forecast already as low as 1.1% – even if validated – the question the ECB is wrestling with is still what it means for risks to 2015 and momentum going into that year and the year beyond?

Long term expectations are relatively well anchored, but that is a necessary condition but not sufficient in and of itself, and the ECB are well aware that expectations could shift rapidly and by then it could be too late to respond effectively.

There is some pricing power and the Eurozone is not in outright deflation, but from what we understand there has been little to no VAT pass through for example in France or Italy as some analysts say, and that means businesses are already just absorbing higher taxes. Prolonged low inflation also works against all the brutally painful fiscal rebalancing in peripheral Europe that has been accomplished to date, making debt payments expensive, as well as hampering the reparations of banks’ balance sheets.

So the numbers remain undoubtedly – and disturbingly – weak, and revisions in January from 0.7% to 0.8% and another 0.8% reading in February are nothing to write home about. Nothing is way off expectations, but stumbling along at these dangerously low levels, the policy issue turns to one of risk management, and the vulnerability to downside shocks and risks. That there is an increasingly global trend to the disinflation only adds to the ECB’s sense of downside price risks.

A Fragile Recovery in Growth

On the growth side, Eurozone survey data and PMIs have been holding up relatively well as an offset to the low inflation, but a few eyebrows were raised recently when the latest PMI number showed some signs of flattening. Indeed, the question of what even just a small dip further would do to confidence and expectations is a point of concern to ECB officials.

Beyond the surveys, there have been some cautiously promising signs of growth, especially in Germany, but concerns remain over not just Spain and Italy among the major economies, but also increasingly with France as well.

French President Francois Hollande’s government has been attempting to stimulate business investment through tax incentives, but is missing badly on deficit targets and has had to offset that stimulus with major spending cuts on top of a VAT hike. French businesses, with little pricing power due to labor market rigidities, can’t compress wages, and are taking any demand weakness in margins.

And while Germany remains strong with even Greece and other peripherals showing signs of recovery, there is a growing realization that the impact of the fiscal retrenchment of southern Europe over the last two years is going to be felt in the data for some time.

Of course there is without a doubt a modest recovery underway in the Eurozone. Furthermore, the US and UK are doing well, and while Asia and EM are weak, what Europe loses in trade may be gained in greater capital inflows (into peripherals, bunds, equities), and the AQR should help confidence in the financial system.

But to concerned ECB officials, that recovery remains modest and fragile at best.

…and Sensitivity to Low Liquidity Levels

On the liquidity and money market side, there also appears to be some sensitivity within the ECB to liquidity dropping below a threshold of roughly 130-150 billion Euros of excess liquidity. That is where the overnight Eonia rate is seen to converge up to the 25 basis points refi rate rather rapidly and messily. But the actual excess liquidity has fallen into a range between 117 to 119 billion of Euros since February 19.

When the ECB provided excess liquidity around its 800 billion Euro peak, overnight rates were close to 10 basis points. As the EL dropped, that rate started to not just rise, but to trade in a much more volatile and variable fashion than when anchored close to either extremes. All that is a way of saying excess liquidity clearly does matter to o/n rates.

The Full “360 degree” View

ECB officials including President Mario Draghi have for some time been stating that they will consider all easing options available to them if needed, and are taking a “360 degree” view of those options. The urgency to act, and what exactly that means, of course, changes over time.

As we have already outlined above and in our most recent report (SGH 2/18/14, “ECB: Supporting Forecasts and Rate Guidance”), we have been expecting and continue to expect some easing on the liquidity front, even at the upcoming March 6 meeting.

That clearly includes a halt to the sterilization of the 175 billion Euros of bonds from the SMP program held in the ECB’s portfolio. That option was only reinforced by the German Bundesbank’s recent public green lighting of it.

There is some debate internally over whether it would make sense to do both the SMP and cut the refi rate, as they would both essentially cap short rates. But some ECB officials are looking at both, if not perhaps even well beyond those limited measures (more below).

There is, incidentally, little to no concern about any damage to the money markets if the refi rate were to be cut to 10 or 15 basis points without a cut of the deposit rate below zero into negative territory, essentially collapsing the corridor even further than the existing 25 basis points spread.

There are also about 400 billion Euros of three year LTRO funds left on European banks’ balance sheets, all of which will roll off around year-end, and we understand the ECB may want to “top this off again” at some point soon, perhaps this summer, before it shrinks too much, with some shorter date LTRO loans.

While Draghi and other ECB officials have said they do not want to simply lend money to banks and thus provide mere “carry-trade” incentives, a top-off could be presented as maintaining the current liquidity, in effect a “roll-over,” rather than encouraging more carry trades per se.

ECB officials also have months and months of studies worth of files in their folders on all the various ways to encourage ABS markets and loans to SMEs (or as Mitt Romney might say, “folders full of ABS”). The ECB could try and build up that market, but as we have said before, that would take so long that by the time they got it going it would really beg the question of what its impact really would be, and whether it have been worth it.

There are some small concrete steps that could be taken on the industry and regulatory side that could help, for example EIOPA, the pensions and insurance companies watchdog, currently has capital requirements for ABS that we are told are six times as high as those required for covered bonds, making it impossible essentially for institutional investors to hold. Even a change there, however, on such a small market would only affect the economy on the margins.

The Big Bazooka: Bond Purchases

One challenge with taking any of the smaller measures is that the ECB officials understand they will immediately have to address what they would do to ease next if needed, and that would be large scale government bond purchases.

The ECB is of course allowed to buy government bonds on the secondary market. They have done so in the past through the SMP program and have threatened to do so with the OMT. They are not allowed to directly finance government debt, and QE has always been extremely politically sensitive.

But here is where there has been perhaps the most quiet, yet dramatic, shift in ECB thinking, namely, what was formerly taboo has become another matter of fact weapon in their arsenal.

In regards to the politics and the German Constitutional Court challenge to the OMT program, that has been kicked over now to the European Court of Justice in Luxembourg, the ECB view is that the OMT program is intended to avoid a break-up of the Eurozone, and so clearly within its mandate. For all practical purposes the court ruling should be moot either way, for the reason that a break-up threat is no longer a real problem – touch wood.

In case of large scale purchases of government bonds, ECB officials understand they would need to make sure they are not distorting one sovereign market over another, meaning they would need to buy German bunds as well as Italian BTPs even though Germany clearly doesn’t need lower yields. That would ensure it is not seen as monetary financing of fiscal policy, but rather as straight monetary policy.

And that is where the Bundesbank’ s already stated support of a halt to the sterilization of SMP bonds on the ECB’s books – on the grounds that it is pure and simple monetary policy – becomes so interesting as a precedent.

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