The European Central Bank (ECB) announced a relatively aggressive deflation-fighting plan this week, in a bid to boost credit to the real economy, but analysts fear the proposed programme could prove too slow and lack the necessary scale in the absence of credit demand as well as fiscal and structural reform.
The asset-backed security (ABS) programme, which will see the ECB buying a broad portfolio of simple ABS and covered bonds starting in October, had been expected, but the unforeseen cut in the benchmark interest rate, from 0.15% to 0.05%, buoyed global financial markets.
Significantly, ECB president Mario Draghi said the purchases would include purchases of existing and new ABS, and residential mortgage-backed securities. Markets had expected a small purchase programme, but Draghi in effect kept his options open by declining to specify its size, though there are an estimated €700 billion of eligible ABS and around double that amount of eligible covered bonds.
Draghi said the programmes could see an expansion of the ECB’s balance sheet – at a three-year low at €2 trillion – move back to 2012-levels at €2.7 trillion, in a move he said constitutes quantitative easing(QE).
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“The definition of QE is not really related to its size but rather to its modalities,” he said. “QE is an outright purchase of assets … rather than accepting these assets as collateral for lending. The ECB would outright purchase these assets. It would inject money into the system.”
The impact on growth and inflation expectations from the programmes is unclear, given the lack of detail on the size, speed, assets and geographical distribution.
“A cut in rates and some firm details on the ABS purchase programme were the easiest things to do,” says Nick Beecroft, senior market analyst at Saxo Bank. “But Draghi sounded like he was out of ammo when he made the point that monetary policy alone won’t work, and we need fiscal and particularly structural reform to achieve Europe’s growth targets.”
By indicating interest rates are at their lower technical bound, Draghi was admitting further rate cuts from here are unlikely.
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“The ABS purchasing programme was expected and without the introduction of QE there was probably a feeling that something had to be done, and thus the decision to cut interest rates,” says Gary Jenkins, chief credit strategist at LNG Capital.
ING analysts conclude: “Yesterday’s measures will not be the big game-changer or kick-starter for the eurozone economy, but at least in the short run the resulting weaker euro exchange rate and financial markets’ buoyance should bring some relief.”
Jose Wynne, head of FX research at Barclays, was more positive about Draghi’s announcement, saying he had found the right policies to reinvigorate the European economy.
“The market has to digest what this ABS programme means,” says Wynne. “Some market participants are disappointed they didn’t see outright QE in the form of government bond purchases, but the ABS programme is the best policy for Europe.
“It will deliver more bang for the buck in terms of its impact on SMEs, which are labour intensive, so it will have an impact on employment. Purchasing ABS will detoxify banks and accelerate the healing process.”
Wynne believes the market is underwhelmed by the ABS measures because it doubts the ECB’s ability to implement them effectively, given the thin liquidity in that market, but he remains confident the ECB will find a solution to these challenges. “These ABS measures are more powerful than the market is pricing in today, but this should be enough to avoid outright sovereign bond QE,” he says.
The interest-rate cut does make the ECB’s four-year loan offers to banks, known as targeted long-term refinancing operations, particularly attractive, though the extent of the take-up is unclear, as excess euro reserves in the banking system are already €118 billion.
CreditSights analysts say: “Banks are likely to try to pass on any excess reserves they hold by using the funds to buy low risk-weighted assets that still pay a positive yield from other banks and institutional investors … As a result, banks’ desire to get rid of any excess reserves by using them to buy other, yieldier assets will create a bid for short-dated euro IG credits.”
Bank of America Merrill Lynch strategists reckon the ECB’s moves are unambiguously positive for credit. “Over time, [the ECB move] means a shortage of assets and a continued shortage of yield in Europe, both of which are big tailwinds for spreads. We remain bullish on credit into year-end.”
However, analysts at UBS reckon long-term core yields should rise, though front-end rates should remain low, given rate cuts and greater excess liquidity. “To the extent that government bond QE is priced in to longer-term core yields, it should now be mostly priced out,” they state.
“Guessing the extent is difficult, as is separating it from genuine worries over low growth and inflation, which should also ease. If any practical problems around the programme are overcome, and that demand for credit is sufficient to lift growth expectations, then yields could rise significantly over time.”
They add: “For the moment, we believe that at least 10 basis points should be added to yields in the 10-year-plus part of the German curve [currently 0.95%] over the coming week or two.”
QE or not to QE
Draghi does, of course, have one piece of ammo left: full-blown QE with outright purchases of sovereign bonds. With the ECB failing to reach a unanimous decision on a rate cut, some have questioned how it can reach a decision on the far more controversial matter of QE. The market might question that if Draghi cannot get agreement on a well-flagged ABS programme, will he be able to deliver on QE, says LNG’s Jenkins.
“[The] meeting will lower the markets expectation of outright QE in the eurozone,” he says. “My own view is that the economic situation would have to deteriorate from this point to enable the ECB to undertake QE.”
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| Source: Eurostat. Data before 1996 are estimated on the basis of non-harmonized national Consumer Price Indices |
“The bar remains high,” says Geoffrey Yu, G10 FX strategist at UBS. “If inflation still won’t move higher, QE will be deployed but there are several steps to surmount.” Ultimately, monetary policy is no substitute for structural reform, adds Yu, citing Japan as a case in point. “The ECB will hope now for more proactive government reforms,” he says.
Saxo’s Beecroft adds: “[Draghi] will be dragged kicking and screaming to QE in the end, by lower growth and inflation expectations and a stubbornly strong euro. But that is a Rubicon for the Bundesbank and the German people to cross, and it will take time.”
However, Barclays analysts are more bullish, saying: “To sum up, after all the measures announced [yesterday], it is clear to us that the next step for the ECB will be full-scale QE, including government bonds.
“This would take place if the macro outlook continues to worsen and/or inflation expectations slide again (including the 5y5y forward). Nonetheless, we still think that if the ECB were to launch QE, it would be most likely by year-end or the beginning of 2015.”
Citi analysts reckon the ECB will be forced to launch more aggressive action later in the year, or early 2015. “This purchase programme announcement is a meaningful step that highlights the strong desire of the ECB to defend its inflation mandate – the introductory statement reiterated the ‘unanimous commitment to using additional unconventional instruments within its mandate’.
“Although there was no unanimity on the modalities, [it] nevertheless acted. Overall, we believe that these announcements will help, but that they are unlikely to be ambitious enough to materially improve the euro-area recovery prospects and lift inflation close to 2%.”
They add: “In the absence of meaningful fiscal stimulus or additional easing, we still expect inflation to undershoot the ECB’s target in the medium-term horizon.”
Euro bets
As the markets digested Draghi’s words, there was an immediate weakening of the euro, which tested the $1.30 mark versus USD.
Opinions were divided on how enduring the reaction would prove. Deutsche Bank analysts say the programme is a smokescreen for currency depreciation. “In being so open about the desire to target a level for the ECB balance sheet, the ECB is indirectly saying it wants the EUR exchange rate to depreciate,” they say.
“The implicit message of currency depreciation is also in the prepared press statement. [Yesterday]’s policy measures support forward guidance and ‘reflect the fact there are significant and increasing differences in the monetary policy cycle between major advanced economies’.
They add: “If the ECB can get the EUR exchange rate to decline – recall, last month Draghi called the weakening EUR the ‘most important’ event of the last few months – it might be the best and most immediate way to bolster growth and inflation expectations, and avoid them settling on to a combined downward trajectory.”
Beecroft says: “The euro will stop weakening soon. I would be surprised to see it go below 1.28 against the dollar, unless we see a catastrophic escalation of events in Ukraine, which is one thing that could push it further.”
While the USD rate is the obvious reference, strength against yen could also be something to watch in coming months, he adds, with the Bank of Japan considering loosening its own rate again and perhaps doing more QE of its own.
“It is absolutely worth noting that the past two ECB rate cuts resulted in a similar EUR plunge only for the single currency to set a noteworthy short-term low immediately following the decision,” says David Rodriguez, quantitative strategist at DailyFX. “It seems as though the euro is at real risk of setting a short-term exhaustion low at or near these levels.”
Others felt the euro had considerably further to fall. “The outlook for the euro-area looks rather gloomy,” says Andy Scott, associate director at HiFX, suggesting the measures will continue to weigh on the euro against both USD and GBP – the Bank of England having left rates unchanged, as expected.
“We continue to look for EUR/USD to end the year towards 1.2500 and GBP/EUR towards 1.3000.”
Jens Nordvig, global head of FX strategy at Nomura, says: “We think there is substantial further downside in store for the next month, with the FOMC [Federal Open Market Committee] meeting on September 17 a potentially very important catalyst for EUR/USD and the dollar broadly.
“The ‘considerable period’ language may be toned down or entirely removed, which will serve to weaken the Fed’s forecast guidance. A level of around 1.27 is likely for EUR/USD by the end of the month.”
Capital Economics projects the EUR/USD exchange rate will reach $1.25 by the end of this year, falling further to $1.20 by the end of 2015 and to $1.15 by the end of 2016, essentially bringing its predictions forward by 12 months relative to expectations before the announcement.
UBS looks at it from a different angle. “The ECB is now a bit further from outright QE so this should mitigate losses,” says Yu. “We like EUR/USD lower, but only if it is a dollar-driven move. The burden of adjustment is now on the Fed.”
The ECB also cut its growth forecasts for 2014 by 0.1% to 0.9%, and by the same amount for 2015 to 1.6%.
HiFX’s Scott concludes: “If governments within the single currency bloc are either unwilling or are prevented from supporting their economies through fiscal measures, at least the ECB can say they did all they could to prevent the bloc slipping into a Japan-style period of deflation and recession/stagnation.”