The latest ECB stimulus package, presented after the 10 March monetary policy meeting, provoked a sense of déjà vu in financial markets. The European Central Bank (ECB) once again left investors distinctly underwhelmed. However, this time we believe the markets have got it wrong. This package of measures is worth a second look.
Timely reminder that there is ammunition for ECB stimilus left
The ECB cut the deposit rate by 10bp and raised the monthly pace of asset purchases from EUR 60 billion to EUR 80 billion – both broadly in line with market expectations. The rabbit that president Mario Draghi pulled out of the hat was the announcement of a new set of long-term fixed-rate loans to the banks, known as Targeted Long Term Refinancing Operations (TLTROs). The ECB stands ready to lend cash, in size, for four years at the negative deposit rate (-0.40%) if banks meet their lending targets. This ingenious innovation in the ECB’s toolkit offers a timely reminder to those who question whether central banks are out of ammunition and has snuffed out market concerns that easing monetary policy is counterproductive because it hurts the banking sector (at least for the time being).
Not only good news for the euro outlook...
The principal disappointment – for foreign exchange (FX) investors at least – lies in the news on short-term rates. The ECB sent a clear signal that further cuts in the deposit rate are unlikely and chose not to relax the restriction on buying bonds below the deposit rate. The name of the policy game is now driving longer-term yields down towards a de-facto floor at the current deposit rate (give or take a premium for securities that are in short supply) rather than driving short rates even lower. Currencies are arguably more sensitive to yield differentials at the front end of the curve than at the back, so the March meeting has been characterised in some quarters as an armistice in the currency wars and even the demise of one leg of the policy divergence trade.
More broadly, many investors believe that the FX channel is the most important aspect of the transmission mechanism in the current environment so this ECB simulus pacjkage may have disappointed markets by creating the impression that the ECB is choosing to relinquish the few effective bullets it has left. We do not buy into this thesis. Further easing of the monetary stance via asset purchases still has the capacity to cheapen the euro (as well as loosening domestic financial conditions) even if it does not involve a change in official interest rates, as the quantitative easing (QE) programmes conducted by numerous central banks at unchanged policy rates have demonstrated.
...or for fixed-income investors?
Perversely, bond investors may have been disappointed by this ECB stimulus package for precisely the opposite reason: that the ECB will no longer need to use additional bond-buying bullets. The credit easing (CE) component of the package – the combination of the TLTROs and purchases of corporate bonds under the QE programme – impressed the market, at least until the news conference began. If you think that ECB CE is a game-changing bazooka that can radically improve the outlook, then you should revise down your expectations of how much QE the ECB will do in the future and revise up your expectations of the future path of policy rates and that sounds like bad news for rates investors. Once again, we think this is an over-reaction: it is a bit of a stretch to think that ECB CE has shifted the eurozone’s inflation problem from mission impossible to mission accomplished overnight.
With the ECB only matching expectations on the increase in the stock of asset purchases and some of those purchases being diverted into the corporate bond market, some rates investors might also have been disappointed by the wall of money coming their way. That too looks like a miscalculation. For one thing, the TLTROs will likely unlock a torrent of arm’s length QE, with banks able to fund purchases of securities at potentially negative rates. For another, future ECB stimulus is now likely to come exclusively in the form of more bond purchases, which means future increases in the stock of purchases in larger increments than the EUR 1/4 to 1/2 trillion we have become accustomed to.
Steering inflation expectations
The process of re-evaluating the latest ECB stimulus package and in particular the new set of TLTROs has already begun. However, some aspects remain difficult to decipher. In particular, Draghi’s enigmatic responses to two questions in the news conference are worthy of further comment: one which hinted that the council was contemplating a fundamental change in monetary strategy in the future, the other which discouraged investors from believing that the ECB had just taken that step.
When asked about his views on price level path targeting – the radical idea that the ECB should aim to overshoot the inflation target in the future to compensate for undershooting in the past and present – Draghi sounded pretty open-minded about re-interpreting the mandate of price stability in the medium term: "we’ll have to define the medium term in a way that, if the inflation rate was for a long time below 2%, it will be above 2% for some time."
Allowing inflation to overshoot and committing to keep rates low
If a central bank wants to engineer an inflation overshoot, it needs to commit to keeping policy loose for too long. If the ECB wanted to do that, signalling that it planned to keep rates on hold until into 2021 would be a great place to start. Indeed, that would be a reasonable interpretation of the signal in the latest set of TLTROs. However, when asked if there was a link between the time horizon over which the ECB is willing to provide fixed-rate funding and the time horizon over which the ECB expects to keep interest rates fixed, Draghi gave a surprising answer: "No, there is no relationship."Going forward, the battle between the inclination to overshoot and the reluctance to commiting to keep rates low for too long must be monitored closely as it will determine the direction of the ECB strategy. Written in London on 14 March 2016