Investors have been braced for more monetary stimulus since late August when ECB President Mario Draghi signalled willingness to take emergency measures to combat the risk of deflation. On 4 September 2014 the ECB’s governing council agreed on a new package of measures. Whether these latest policy measures ultimately lead to outright purchases of government bonds remains to be seen. In the meantime here’s our analysis of what the ECB has announced:
Markets were on tenterhooks ahead of the meeting on 4 September of the European Central Bank’s (ECB) governing council in anticipation of hints by ECB President Mario Draghi about imminent quantitative easing (QE). During his press conference Mr Draghi helpfully defined quantitative easing, saying it is “a programme of direct, broad based asset purchases, financed by an increase in central bank money”. Under this definition, the ECB is now engaged in QE. However, the ECB disappointed expectations among those folks who believe fully-fledged QE necessarily includes purchases of large amounts of government bonds (rather than the credit assets like Asset-backed Securities (ABS) and covered bonds that the ECB intends to buy from October onwards). QE was discussed during the governing council’s policy meeting though the vote in favour of the bond-buying scheme and interest rate cut announced was not unanimous. Some committee members would have liked to see broader action, others less.
The ECB has thus responded to the weakening growth momentum. Our conclusion from this policy response is that considerations about economic growth are likely to play a bigger role in monetary policy in the coming months. Usually the ECB focusses more on inflation, traditionally the only needle in their compass. Currently, with inflation extremely low and growth momentum weakening, growth has become more important in preventing the eurozone from slipping into deflation. So, renewed evidence of weakness in economic growth could trigger additional action. Correspondingly an improvement in prospects for growth could reduce the willingness for more action.
Further leeway in cutting rates has been exhausted with a key rate cut to 0.05% (from 0.15%). Stimulus from this move will be limited. The ECB also cut the deposit rate, the rate at which banks can park excess cash reserves at the ECB, by 10 bp to -0.20%. So the interbank rate, or Eonia, may stay negative. It will thus be costly for banks to hold excess liquidity. If the ECB wants to increase liquidity, (as per its announcement in June via new four-year loans (TLTROs)), the negative interbank rate may even be counterproductive. The rate cut was at least successful in further weakening the euro. This may in fact be the biggest impact of this decision.
As had been expected, the ECB has unveiled further measures to revive lending, via TLTROs, purchases of ABS and a new programme for covered bond purchases (the details of which will be announced after the ECB meeting on 2 October). Draghi said that precise impact on the ECB balance sheet is difficult for them to estimate. Our conclusion is that a quick move to fully-fledged QE (with sovereign bond purchases) is unlikely. However, the volume of TLTROs requested by the banks and the volume of ECB purchases under the programmes announced so far will be among the criteria for the ECB to review when deciding whether additional action is needed.
Regarding the possible volume, research by the Brussels-based Breughel institute suggests that after subtracting volumes already used as collateral at the ECB the amount of covered bonds and ABS available to be purchased could be roughly EUR 1500 billion. The eligible volume will be lower, depending on the rating and the willingness of current bond holders to sell assets. Assuming that ECB is not willing or able to buy more than 30% of the outstanding volume, EUR 500 billion seems quite ambitious and the realised volume will be probably much lower. Taking the EUR 500 billion number and spreading the buying over two years means the ECB could buy EUR 20 billion on a monthly basis.
If this were achieved it would be sizeable. But at roughly 5% of GDP, it will be small compared to what other central banks have done. Under their QE programs, the US Fed and the Bank of England bought assets equivalent to almost 25% of GDP, mainly government bonds. If there is need for additional action, ECB could try to extend their programme to other types of asset. The availability of new instruments permitting a broader securitisation of loans would facilitate such an expansion. Taking into consideration the numerous potential operational problems involved in buying assets in different, non-sovereign-bond market segments (liquidity, mispricing resulting from the ECB’s actions, transferring of credit risk to the ECB, etc.) buying government bonds would be required if, at a certain point, a bigger volume is required. In other words if the “volume required for QE” could be achieved by buying non-government assets (credit easing), the ECB would probably prefer this, but at a certain point in time there may be no alternative to the acquisition of government bonds.
After today’s action the ECB can argue more stimulus is in the pipeline. There are also options to do more and this should be monitored closely. These measures will help fight the build-up of deflationary expectations. The ECB is on a path to respond to the environment and growth will have a greater influence on their policy making. This will ultimately determine whether QE is the final destination (“if needed”) or not. At least hope for it will be alive for the foreseeable future in the markets.
The Multi Asset Solutions Tactical Asset Allocation team is already positioned for an improvement in European, ex-UK, assets; equities in particular but also peripheral bonds and credit (including high yield). Our rationale for this view is based on the following observations:
- Valuations in the eurozone look more attractive especially against the US, having been cheapened by the troubles in Ukraine.
- We have upgraded our assessment of the eurozone banks as deleveraging is progressing well, Tier 1 ratios have improved and funding conditions are very accommodative (see above).
- Improvements in US growth prospects and stable growth in China will support the export-led eurozone economy and corporate earnings. The recent 7% fall in the euro versus the US dollar will also be supportive.
Taking a step back and considering the post financial crisis catharsis, we have to remember that the eurozone is three years behind the US. Rewinding the clock in the US to 2011, we observed gridlock in US government, no jobs growth, fears about deflation and an active central bank. Sounds familiar?
Written by Colin Graham and Joost van Leenders