Draghi wows but market remains fixated on QE

Sid Verma, Solomon Teague
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Analysts are divided over the outlook for the euro and the likely potency of the ECB latest monetary-easing measures, after Thursday’s meeting that saw the central bank cutting rates and announcing the October launch of an ABS purchasing programme. While the measures will buoy credit at the front-end, the jury is out on full-scale QE in the coming months.

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).


"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.


"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.