The Governing Council of the European Central Bank will meet a week from today, March 10, to decide if additional easing is necessary, and if so, what measures to adopt.
The answer to the first question is easy: the ECB will ease. The answer to the second question is far trickier as the pre-meeting purdah sets in, simply because there is no consensus coming together yet on which of their options to choose, even as they feel under pressure not to disappoint expectations again after the nasty communications breakdown that occurred with markets when they eased at the December 3, 2015 meeting.
That said, here is our understanding of at least five options ECB officials will be considering next week, in the order of what we believe to be their likelihood:
** Deeper into negative rates, with a cut in the deposit rate
There is a near-certainty the ECB will cut the deposit rate at least another 10 basis points deeper into negative territory, from -0.3% to -0.4% (see SGH 1/21/16, “ECB: Cutting Rates and Expanding QE in March”). We believe there is beyond that an even chance they choose to cut by more than that, by 15 or even possibly, but less likely, 20 basis points.
For all the negative reaction in its domestic banking sector to the Bank of Japan’s decision to go into negative territory, a majority of ECB officials still consider a rate cut deeper into negative territory to be less controversial than the other options. In addition to providing that much more stimulus, a deeper cut in the deposit rate also helps address some of the constraints the ECB will be facing down the road on its existing bond purchase program, and opens room for the possibility of an increase in the size of its monthly purchases.
That would especially be the case if its negative impact on banks can as expected be mitigated through a tiered system such as exempting excess reserves at certain levels from the deeper negative penalty rates. The ECB had weighed resorting to a tiered system when it cut rates in December from -0.2 to -0.3% but decided against it for reasons of simplicity and effectiveness. We think it will be adopted this time around due to the increased focus – rightly or wrongly – on cushioning European banks from additional margin and lending pressures.
A cut in the deposit rate will also alleviate some of the constraints the ECB may in the future face in the supply of government bonds available for purchase, which would also open the room for a modest step up in the pace of QE.
** Increasing the monthly bond purchases
With concerns mounting that the staff economic forecast revisions will now downgrade growth as well as inflation, we suspect there is a, say 60-70% chance, of a modest step-up in the pace of bond purchases pace by 10 or at the most 15 billion Euros per month.
But that said, with German 10 year bunds already yielding as low as 14-15 basis points we do detect less enthusiasm or energy around an aggressive step up in the 60 billion Euros per month pace of bond purchases.
For one the ECB already extended its purchase program in December by six months, from at least September 2016 to March 2017, and committed itself to the reinvestment of securities as they mature. ECB officials have estimated these measures to translate into an extra 680 billion Euros in bond purchases, a message that is sure to be hammered home again, along with the significance of the commitment on the reinvestment of securities that is estimated to comprise 320 billion of that 680, or the equivalent of roughly an extra 20 billion Euros per month of purchases on a monthly flow basis.
The ECB could of course also simply further expand the universe of assets it will purchase under the Asset Purchase Program (APP), as it did in December when it added municipals and regional bonds to the mix.
If it were to do so, the next asset class under consideration is and has been corporate bonds. While this is certainly possible if not plausible, officials repeatedly note that the Eurozone corporate debt market is still relatively small, and we suspect they may instead continue to keep their focus on ways to buy more government, supranational, and municipal bonds.
We do not think the ECB will seriously consider the purchase of unsecured bank bonds at this juncture, and most certainly not equities.
** Tweaking the bond purchases
Another alternative solution we understand to be under consideration is to keep the program size the same but “front-load” the pace of purchases of the current program from the steady 60 billion Euro per month pace. While that would get around some of the concerns over capacity constraints, it could create a negative “cliff” effect on the back-end when purchases are tapered, and so we believe a modest increase in the net monthly purchases to be more likely.
There is also a good deal of market speculation the ECB may choose to switch its bond purchase guideline away from following “ECB Key” proportions to a “market size” based program, which would redistribute purchases away from the ultra-low yielding German bunds towards higher yielding Italian BTPs and other peripheral markets that are in greater supply.
We do not think the ECB will do that. A market size approach was indeed under consideration as an option when the APP program was first being developed in 2015. But to switch midstream now would raise serious political questions around moral hazard, reverse incentives, and the like. In addition the Italian and Spanish central banks are already seen to have been aggressive purchasers of their own government bonds under the ANFA (Agreement on Net Financial Assets) program, even though these purchases are ostensibly for technical and not monetary policy reasons.
One intriguing option we do understand to be under serious consideration to help free up the supply of bonds available for purchase is to raise the self-imposed 33% limit per issue and loosen the equally self-imposed case by case restriction on the ECB purchasing bonds above a threshold that would give it a controlling Collective Action Clause share in case a bond should ever be restructured.
While still controversial, and potentially opening the door to yet more legal challenges, the argument is that concerns over a restructuring of the more highly rated sovereign bonds should not be a factor to the ECB for practical purposes.
** Shoring up the bank balance sheets
There is also a good deal of speculation the ECB may take measures to directly shore up bank balance sheets, and in the process enhance the transmission mechanism of its easing policy into the real economy. One option would be to provide additional TLTRO lending.
But with ample liquidity already in the system, we do not sense a great deal of urgency around this option. If it is indeed announced, we believe it would be with the intent to strengthen the ECB commitment over time – i.e. a longer duration than current programs – rather than to inject even more liquidity in the short term into the system.
** Other easing options
Along those lines, and in the general category of “other” easing options, we suspect the ECB may look for other ways as well to strengthen its forward guidance on top of the current commitment to purchase bonds until March 2017 and even beyond if necessary.
We believe that will take the form of emphasizing the commitment to continue the program even as the economy (and inflation) pick up, and a renewed emphasis on the additional stimulus the reinvestment of bonds will provide come March 2017 when the first of the two year bonds the ECB has purchased will come due.
And intriguingly, there also may be some consideration on the fringes of using derivatives, such as selling put options on either bonds or inflation-indexed rates, to reinforce the ECB commitment behind its mandate. The use of derivatives for those purposes was an option under consideration in 2010 by the Federal Reserve, but it was not adopted by the Fed, and we would be (pleasantly) surprised if the ECB were to adopt it as well.