Summary of our analysis of the decisions announced after the ECB monetary policy meeting on 10 March:
After announcing measures that fell short of market's expectations at the monetary policy meeting in December, the ECB went for a big-bang approach on 10 March. Markets, however, have already seen this film and were not particularly impressed by the special effects.
The ECB does not consider it is running out of ammunition, but the policy focus is shifting away from interest-rate policy towards non-conventional tools.
Market scepticism about the effectiveness of monetary policy in general could diminish the impact of further ECB action.
These latest measures do not, in our view, represent the game changer some market participants were anticipating. We prefer a cautious positioning in European assets for now.
At the news conference after January’s meeting of its policy-setting council, the ECB had indicated that more action was to come. However, senior ECB board members had since been (deliberately) vague about the instruments to be employed. In recent weeks, ECB council members appeared to be seeking to downplay the market expectations. At the same time, a debate has been raging among market participants about the (in)effectiveness of monetary policy in general and the possible harm that negative deposit rates may have on the capacity of banks to lend.
As the monetary policy meeting on 10 March of the governing council approached, broker research had raised expectations in financial markets that the ECB was preparing to announce significant policy measures. Determining the extent of the market's expectations became harder for the ECB. In this environment, it opted to announce a raft of measures.
What is in the latest ECB monetary policy package?- Cutting its main refinancing (refi) rate by 5 basis points (bp) to 0%, accompanied by a 10bp cut in the deposit rate to minus 0.4%
- Expanding, as of 1 April, the volume of monthly asset purchases under its Asset Purchase Programme (APP) by EUR 20 billion to EUR 80 billion. There was, however, no extension of this quantitative easing programme beyond March 2017
- Adding, under a new programme, investment-grade, non-bank, euro corporate bonds to the list of assets eligible for purchase by the ECB
- Starting in June 2016, a new TLTRO (Targeted Long-Term Refinancing Operations) programme. Under this programme, the ECB will auction cash to banks once each quarter between June 2016 and March 2017. Eurozone banks will be able to bid for cash up to an amount corresponding to about 30% of their loan book. They will pay, at most, nothing for the four-year loans, which will have to be paid back by 2020 at the earliest. If eurozone banks lend more (than 30% of their loan book), the ECB will lend cash to them at a rate of minus 0.4% (banks in the eurozone are essentially being incentivised to increase lending to households and companies). This may sound radical, but previous TLTRO operations (in September and December 2014) were not as effective as the ECB had hoped (it takes two to tango - companies and households have to want to borrow for such a programme to really take off).
Aligning with market expectations
In our opinion, the increase in the volumes of assets to be bought and the expansion of the range of eligible assets to include corporate credit were an attempt by the ECB to surprise markets positively and avoid another disappointment. Initially, the reaction was euphoric - the euro lost roughly 1.5 cents against the USD, 10-year Bund yields fell by 6bp to 0.16% and the EuroSTOXX equity index rose by roughly 3%.
However, 10-year yields and the euro subsequently reversed course and ended the trading day of the ECB announcement above the levels at which they had been trading prior to the news. Equities also gave back their gains.
We expect the potential contribution to real economic growth the ECB will make via these additional measures to be limited. The main impact will be:
(i) shoring up economic growth in the face of short-term jitters
(ii) improving financial conditions via purchases of corporate bonds.
In addition, over the medium term, the TLTROs and the expanded QE programme should keep yields low for longer and help the central bank fight the build-up of long-term deflationary expectations.
The ECB delivered substantially more on 10 March than it did at the policy meeting in December, but it can be hardly satisfied with the ‘bang obtained for its buck’ in terms of the market's response, on either occasion. This could be a painful lesson for the ECB.
We see no reason to believe discussion in the ECB council about the need for further easing of monetary conditions will cease. A key message from the council at this meeting is that the ECB does not consider it is running out of ammunition ("We have shown we are not short on ammunition,” insisted Mr Draghi). Nonetheless, its focus does appears to be shifting away from traditional interest-rate measures towards non-conventional policy instruments. It is this shift that may partly explain the disappointment in the initial reaction of bond markets.
The ECB looks to us as if it has been boxed into a corner by its own rhetoric. It is not the only central bank that has found itself cornered after having given the impression that monetary policy measures alone would be able to generate economic growth and inflation in the short term. As the effectiveness of this stance is increasingly questioned, we believe there is a risk that further measures could be seen as action for action’s sake and actually become counterproductive.
The latest monetary policy measures illustrate to us that the persistent undershooting of the targeted path of inflation (see exhibit 1 below) has put the central bank under pressure to take far-reaching action, even if one were to consider the recent plunge in oil prices as the main culprit.
The fact that the rate of inflation in the eurozone has been so far below the objective for so long (2016 is likely to be the third year that inflation runs at less than half the ECB's target of 'close to but below 2%') means its target has lost credibility. This is now being reflected in market-based expectations for the future rate of inflation. These are clearly key concerns for the ECB.
In this respect, the ECB's first projection for the rate of inflation in 2018 is important: the ECB forecasts inflation of just 1.6%. In our view, the ECB will, on account of the huge output gap in the eurozone and the low level of unit labour costs, have an uphill task in meeting the inflation target not just in 2018, but beyond that date too. The pace of growth of unit labour costs is currently hovering at around 1%. These costs are an important factor in determining the rate of core inflation (see exhibit 2 below) - also, currently, running at a level far below that desired by ECB policymakers.
Exhibit 1: the persistent undershooting of the ECB's targeted path of inflation has put the central bank under pressure to take remedial action (the graph shows changes in the annual inflation rate for the eurozone for the January 2010 to March 2016 period).
Source: Bloomberg, as at 11 March 2016
Exhibit 2: the rate of core inflation in the eurozone remains well below a level that would correspond to the ECB's reflationary objectives
Source: Bloomberg, as at 11 March 2016
So, in our view, further action remains on the agenda. However, after the latest decisions, we do not expect new measures until the second half of 2016 at the earliest. Any impression that the ECB is now done may well therefore be premature. In our opinion, further steps will depend on incoming economic data. In the course of 2016, pressure for additional action would ease if:
(i) the oil price rose to above USD 50 per barrel
(ii) growth picked up in the eurozone and
(iii) the euro weakens.
A cautious view on European assets
As said, the positive reaction in bond markets was short-lived as participants took the view there was now less to expect in the foreseeable future from the ECB. If economies in developed countries show more signs of reasonable growth and expectations of further interest-rate increases by the US Federal Reserve this year are revived, market vulnerability could rise further. Prolonged asset buying by the ECB could result in a negative supply in eurozone government bonds. Together with more negative money market rates, anchored for longer, this should prevent a sharp and prolonged rise in yields. Nevertheless, as in 2015, a low-yield environment does not mean low market volatility and ECB buying is no guarantee for positive returns in bond markets.
As for European equities, we currently prefer a more defensive stance. Sentiment should get a further boost from the QE expansion and could unwind somewhat further the market’s extremely pessimistic view of the global economy. However, we see few other drivers to lift the market’s spirits. Overall, global corporate earnings trends look less supportive now than they did a couple of months ago. In Europe, there are geopolitical issues that look set to weigh on equities in the next few months including June’s EU referendum in the UK, forming a stable government in Spain and the refugee crisis.
Such issues could in the medium term add to the weakness of the euro, but we believe Fed policy will be the main driver. Opportunities for additional US dollar strength could present themselves as the Fed resumes its slow-motion policy tightening later this year.
This article was written in Amsterdam on 10 March 2016.