Future generations of savers may search for bonds bearing positive interest rates like pioneers in the US gold rushes during the 19th century.
In August, risks around the Sino-US trade war and Brexit appeared to be one trigger pushing interest rates down to record lows. This occured despite the fact that the global economy is not doing so badly.
Admittedly, there are risks to trade and industrial activity in several major economies. Most economic indicators are pointing to resilience in services activity and hence in domestic demand. Some central banks, including the European Central Bank, have already lowered policy rates to below zero. September’s meeting of the ECB governing council was therefore seen as important in determining how the negative interest rate environment may evolve.
Over the summer and following on from Mario Draghi’s speech at the symposium in Sintra and the monetary policy meeting on 25 July, the ECB surprised us by setting the stage for a relaunch of its asset purchase programme in addition to a possible cut in its key rates (which was seen as a less surprising announcement).
In our view, economic conditions are not so bad in the eurozone. The risk of deflation remains low, even though core inflation is at around 1%. Moreover, the euro remains low against the US dollar (at around 1.10 in early September), while the ECB’s threshold for action seems to be around 1.20.
Accordingly, several members of the ECB’s governing council had indicated since late August that they were reluctant to restart the purchase programme, but more willing to lower the deposit rate.
An extensive package, but still somewhat disappointing
In the face of the high expectations the ECB had helped create, the latest policy decisions (see below) may, at first glance, appear a little disappointing, even if the ECB did announce the ‘broad instrument mix’ that had been mentioned in the minutes of the July meeting.
- Deposit rate cut by 10bp to -0.50%, with other policy rates unchanged
- A resumption of the asset purchase programme (APP) from 1 November at a relatively modest pace (EUR 20 billion per month), but without a set time limit
- Continued reinvestment of the repayments of principal on securities held on the ECB’s balance sheet at maturity
- Adjustment of the terms for the ECB’s third longer-term refinancing programme for banks (TLTRO III) so that their conditions remain attractive
- Implementation of a two-tier system for reserve remuneration (a modulated or tiering rate to facilitate the transmission of monetary policy by the banking system by exempting a portion of the excess reserves banks hold at the ECB from the -0.50% deposit rate); to some extent, this addresses concerns about the consequences of negative policy rates for banks’ balance sheets.
Call for fiscal action too
The tone of Mario Draghi’s press conference left little doubt about the accommodative nature of these measures, although it was not entirely convincing. Perhaps the end of the introductory statement should have received more attention.
The ECB explicitly mentioned that ‘in the face of deteriorating economic prospects and downside risks, governments with room for fiscal manoeuvre should act with efficiency and speed.’ During the question and answer session, Draghi noted that this phrase had been added to the paragraph on fiscal policy and had significantly changed the message.
Table 1: The ECB has revised down its growth and inflation forecasts
Our analysis of the latest ECB announcements and market reactions
For his penultimate meeting before the end of his term of office, Draghi probably sought to satisfy investors’ expectations, while at the same time managing those governors not completely aligned with his views. The objective was to not leave a governing council with major divisions to Christine Lagarde, who will take over the presidency of the ECB on 1 November.
This approach led to decisions that raised questions about their effectiveness. Hence the mixed and sometimes confused reactions of financial markets (including a rise in the yield of the German 10-year Bund).
- The relaunch of QE is good news, but the relatively modest amount of purchases each month may limit its effectiveness. The terms and conditions have been modified at the margin: The ECB does not prohibit purchases at rates below the deposit rate on government bonds (which was already the case previously). Purchases of corporate bonds and covered bonds are permitted. By contrast, the maximum holding threshold of 33% was not raised. QE operations will therefore be carried out at a modest pace and will, inevitably, be constrained over time by a lack of sufficient supply of securities.
- As for tiering, designed to avoid a ‘penalty’ for European banks (linked to the negative deposit rate), the introduction of a rate of remuneration on a portion of excess reserves at 0% in parallel with the banks’ three-year refinancing operations (TLTRO III) may pose problems.
- The ECB’s call for expansionary fiscal policy is an important point, but will governments respond quickly enough?
What to look out for now
The latest ECB council meeting still encourages the market in its unbridled search for yield.
Despite investor reactions to the ECB’s news being perhaps less exuberant than Draghi would have anticipated, the environment remains favourable for borrowers. It now is to be seen whether governments will announce fiscal expansionary measures, be it in Europe or the US.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.