The European Central Bank Governing Council took a major step at its monthly April 3 meeting in announcing a unanimous commitment to embarking on new and unconventional policy measures if needed to hit its inflation target, and if those measures were to fall within its mandate.
This was a nod, among other measures, most importantly to “quantitative easing,” as emphasized in President Mario Draghi’s subsequent testimony, with new-found consensus riding the wave of a new-found willingness of the conservative German Bundesbank to consider unconventional tools.
Draghi, however, left key questions unanswered, among them the triggers for further easing, parameters of various policy options, including QE, and the most likely policy responses to different scenarios. Those questions are still very much in the air, and open to public comment and interpretation by numerous other ECB officials, often with differing viewpoints; and in the process, the cross signals have generated a new round of questions in markets over how much of the newly found dovishness is rhetoric, and how much is reality.
Inflation and the Euro
The ECB’s “base scenario” expectation (hope/preference) is that the next rounds of inflation numbers will show some bounce back from the recent string of below forecast misses on already expected weak numbers, and with it confirm a long-awaited stabilization and normalization for the second half of 2014. ECB officials have in the meantime urged patience, pointing out that a full 75% or so of the drop in inflation since the end of 2012 has been due to falling energy prices (a good thing), and a good portion of the remainder is due to the necessary adjustments in competitiveness levels in the peripheral countries that will soon reverse as those economies rebound.
That gradual reversal and normalization would allow the Governing Council to stay on hold, which after all is its preferred option at these ultra-low interest rate levels. But there is growing unease beneath the “stay the course” policy that some of the drop in energy is in fact currency related – in dollar terms energy prices have been relatively stable, it is the Euro that has appreciated to lower energy prices – and therefore won’t reverse unless the Euro were to drop. The ECB has now attributed 0.4-0.5% of the drop in HICP since 2012 to the strength of the Euro. And part of the drop in energy in fact is a reflection of weak demand eroding pricing power at the refinery level, and not the reflection of more benign supply dynamics at work.
As to the fiscal adjustment effect in the peripherals, while Spain especially is expected to show some positive signs of growth that should pull its inflation numbers up over time, there is some concern now that Italy, and most importantly France, are only just experiencing a new wave of downward price pressures, with little in the way of improved competitiveness to show for it.
There has therefore been a concerted effort by ECB officials since last weekend’s IMF meeting in Washington to express a desire for a weaker currency and jawbone the Euro lower, emphasizing the risk of the strong (or stronger) Euro to its inflation forecast. It is worth noting that the ECB’s already tepid March quarterly staff inflation forecast is based on a going forward Euro dollar exchange rate of 1.3600, but the currency has traded above that level for the bulk of the last four months.
Uneasiness with the tepid inflation numbers and forecast had been building up within parts of the ECB from even before the March ECB monthly meeting, and before the public (but probably necessary), berating from IMF officials on the dangers of “low-flation” (see SGH 2/28/14, “ECB: Signaling the QE Option”).
Since then, the 0.5% March HICP reading came in, from what we understand, a good 0.2% or 0.3% below the ECB’s own internal forecasts, which had already factored in the Easter calendar effect from last year that many analysts later pointed to as a reason for the big downward miss. The magnitude of that miss, after the sixth months of sub 1% inflation, will be significant in lowering the bar and coloring the willingness or ability to look through further lackluster inflation numbers were they to materialize over the next two months, and in their impact on the June forecast revisions.
Tools of the Trade – Negative Deposit Rates
Cutting deposit rates into negative territory, and with it creating a negative interest rate carry for the Euro, is understood not just by markets but by ECB officials as well to be the most direct tool for addressing currency strength. But it is also seen to be a rather limited tool for the real economy, which carries with it some potential negative side effects as well.
There have therefore been discussions in the ECB over experimenting with a small, symbolic -0.10 or -0.15% deposit rate, but from what we understand the outer limit for negative rates is realistically seen to be not much lower than around -0.25%, with anything approaching -0.50% considered close to territory that could create distortions such as perverse incentives for hoarding cash, or harm the banking sector. And so while cutting rates into negative territory by a small amount is eminently feasible and a real option under consideration, there is still a bit of hesitation within the ECB in embarking on what could be a rather limited tool specifically targeted to weakening the currency.
Furthermore, while at current ultra-low inflation levels there is clearly a great deal of sensitivity to the level of the Euro, in the big picture the Euro is not seen as tremendously misaligned from its long run average rate, and the preference is to have fundamentals drive the currency if at all rather than having to do it through ECB intervention. The failed experiences in the pre-Euro era of competitive devaluations fueling inflation and dis-incentivizing reform (that usually means Italy) still lurk in the backs of the minds of many ECB officials.
We nevertheless do not rule out the option of a small ECB cut into negative rate territory (along with a cut in the other market rates), as that is clearly the lowest hanging fruit among the tools to hit the Euro, and a “stepping stone,” or a way to buy time for more complicated ABS purchases, and the even more controversial, potential regime change sovereign asset purchases.
What about this “European” QE?
Discussions within the ECB over a “Eurozone version of QE” have evolved along two tracks, the purchase of ABS, bank, or other private securities, and the purchase of sovereign debt in Europe’s pan-European fragmented government bond market.
For all the stated preference for studying the former, as the less politically controversial choice than sovereign purchases, many senior ECB officials fully understand that creation of an effective ABS market and purchase program, which is undoubtedly the most targeted and clear transmission mechanism for getting needed credit to medium and smaller business, is simply not a realistic near-term policy lever due to the tiny size of the market (much of it in fact currently concentrated in Germany and the Netherlands). Furthermore, it will take a tremendous amount of time and effort to build that up to a level where it will actually have a macro impact on the economy.
Sovereign bond purchases, for all the political mandate and implementation challenges they pose, are seen as the far more powerful tool of the two in the near term, even despite Draghi’s mention at the last Governing Council meeting of their more muted transmission mechanism through the capital markets in Europe, which is more dependent on bank lending for credit than the United States.
And the debate over the two options, as we have been saying, does not translate into a question of choosing one over the other, as has been often presumed by analysts and the press, but rather into potentially staging and pursuing both tracks.
ECB officials will not affirm or deny recent reports in a German paper that a one trillion Euro sovereign bond purchase simulation exercise was recently conducted to gauge the feasibility and impact of such a program. But we understand they have, as any prudent central bank would, in fact been studying the pros and cons of this as one option available to them.
The biggest obstacle to sovereign bond purchases is not the lack of a pan-European risk free market (akin to US Treasuries) and the fragmentation of European government bond markets. While complicated, this can be addressed through a cumbersome but doable program of allocating purchases between various member countries on a pro-rata level on the basis of GDP, ECB key weighing, or bond market size.
The real complications lie in overcoming the political and philosophical tensions that remain in buying bonds in order to drive rates lower that would ostensibly include peripheral countries, some of which are now trading close to or even below certain US rates. There is of course also the evergreen hesitation in re-opening a political challenge from Germany to the ECB’s mandate and restriction on the monetization of debt were it to buy sovereign bonds, even though legally speaking, sovereign bond purchases strictly for monetary policy are definitively and well within its mandate.
This political sensitivity incidentally also explains why the ECB balked at halting the sterilization of SMP bond purchases at its March monthly meeting. It was, indeed, as stated shelved as deemed to be too limited (175 billion euro) of a tool, but underneath that decision were also concerns over needlessly jeopardizing the ECB’s credibility with some of its more hawkish member state populations.
The ECB had in fact originally promised to sterilize the SMP purchases, and a reversal of that decision to sterilize the bonds, even if termed as a “suspension” and agreed to by the German Bundesbank itself, was seen as potentially and needlessly, for little gain, bringing into question similar assurances over the OMT program currently under review by the European Court of Justice in Luxembourg.
Sovereign bond purchases could certainly face a similar political resistance, but at least that would be for a much more substantive program with a far more demonstrated, and clear, monetary policy necessity.
AQR Timing, Peripherals, and Implementation Challenges
In the meantime, the ECB’s ongoing Asset Quality Review of European banks also poses a timing challenge to any potential sovereign bond purchases. It would seem awkward, to say the least, to be stress testing banks on their sovereign bond holding among other assets while driving the prices (and incentives for owning those bonds) up at the same time.
The results of the AQR and accompanying stress tests are slated to be released in November, which will remove at least this logistical complication. But if push comes to shove we do not believe the ECB will necessarily wait until then to buy bonds. There have been suggestions that a bond program could be accompanied with macro-prudential guidelines, or regulations, to limit, or cap ownership by banks and avoid a potentially dangerous spiral of bloating bank balance sheets up with so many bonds that it would complicate the ECB’s eventual exit (in other words, a Japanese JGB/banking system scenario).
On the cross border level, the irony is that it is the very nations that have benefited the most from recent ECB action and verbal interventions – the peripherals – that are still experiencing dangerously low inflation, even though that is expected to pick up. And so deep down there is some discomfort among many ECB officials in driving these yields and spreads even lower yet.
Even within Spain there is a rift growing between the government of Prime Minister Mariano Rajoy, who along with his counterparts in Italy and France is exhorting the ECB to do more, and his own Central Bank Governor, Luis Maria Linde, who is toeing the more sanguine ECB line on the Spanish recovery.
If and when the time comes, the political tension over how to effectuate bond purchases across the Eurozone may resolve itself in an interesting compromise that we have only just begun to pick up: that is to possibly consider the credit ratings of sovereign bonds along with the other metrics (market size, etc.) in determining what bonds the ECB is to buy.
This focus on protecting the ECB balance sheet though higher quality sovereign purchases already exists in the parallel proposals for the ABS and credit markets. If translated to sovereigns, it could have the very interesting effect of favoring not just Germany, that certainly does not need stimulus, but France (and Finland), that actually need the stimulus, for example over some of the lower rated peripherals.
One thing that is clear, however, is that if and wherever the spectrum of sovereign bond purchases does eventually fall, the ECB will from what we understand not purchase the bonds of a country that is in a bailout program, as that country, by definition, is out of the markets. Portugal will be out of its program and back in the market soon – we have been expecting around the middle of this year – so that in reality would mainly affect Greece and Greek markets to the extent that recent investors may have been banking on QE to provide an eventual bid for their bonds (Cyprus, the other program country, has a negligible bond market).