ECB rate rise next year not a done deal

In June, the ECB announced it was likely to end its net asset purchase  programme in December and that it expected to keep interest rates at their present level ‘at least through the summer of 2019‘ , albeit with a caveat relating to inflation developments remaining in line with the Banks expectation of a steady convergence to target. Some confusion ensued as to when the summer actually ends but the ECB has since indicated it is happy enough with market expectations of a rate rise at the September or October meetings next year.

Any change is more likely to initially  involve the  ECB’s Deposit rate rather than the Refinancing rate, and the latter is more significant for existing Irish mortgage holders as Tracker rates account for over 40% of the stock of mortgage loans.However,  it would then  only be a short period of time before a rise in the refinancing rate occurred if the ECB was  set to embark on monetary tightening.

Why has the Governing Council decided to signal a probable rate rise? In part because the EA economy performed strongly in the latter part of 2017 and although growth moderated in the first half of this year, to 0.4% per quarter, that is still above what the Bank considers to be potential, which has resulted in further falls in the unemployment rate. The ECB is also more confident that wages are finally responding to the tighter labour market, and as a result expects underlying inflation to pick up steadily , with the ex food and energy measure forecast to average 1.8% in 2020 from 1.1% this year. As such , the Council is more confident of a ‘sustained convergence’ in headline inflation to target.

In fact headline inflation has been above target for the past four months, oscillating between 2% and 2.1%, boosted by higher energy prices. Yet that is also squeezing household incomes ( wage growth was 1.9% in q2) and core inflation ( which excludes food , energy, alcohol and tobacco ) has remained stubbornly at 1.1% or below in recent months, slipping back to 0.9% in September.

The  economic outlook also looks less robust than it did. The ECB maintains that the risks to EA growth are balanced but at their September meeting  it was noted that a case could be made that the risks had tilted to the downside. Since then , the global outlook certainly seems to have deteriorated amid a backdrop of falling equity markets, rising trade tensions, weaker growth in China, a rising dollar, Brexit uncertainties and  Italy’s apparent willingness to breach euro fiscal rules.

Indeed, some of the hard data in the EA has been noticeably weaker over the summer months and the PMIs have also softened, with the latest reading for the EA as a whole dropping to a 2-year low of 52.7 in October, That is consistent with GDP growth of only 0.2% a quarter and it will be interesting to see whether the ECB reiterates its balanced risk view at the upcoming meeting.

It may be that the current weakness in sentiment and activity proves temporary but what may also concern the ECB is that more forward looking indicators also signal weakness ahead. The major European equity indices are all heavily in the red year to date while monetary indicators are not reassuring; M3  growth has slowed to 3.5% while the growth rate of lending to the private sector has remained becalmed at 3.4% in recent months, with mortgage lending slowing a little to 3.2%.

It is unlikely that the ECB will do a volte- face on its forward guidance at this juncture but the risks to their view on inflation have risen and it is not a done deal that rates will rise in 2019.

The exchange rate and oil price, not growth, key for ECB QE exit

The consensus was badly wrong on the euro zone last year, significantly underestimating the pace of economic growth and the single currency’s appreciation against the US dollar. This year, growth is expected to remain strong and the euro is generally forecast to appreciate modestly, while many believe the ECB will cease its net asset purchase programme by year-end, with a strong majority of analysts also expecting that to be followed by a rate rise in 2019.

The ECB staff forecast also projects above-trend growth for the next three years, resulting in a steadty decline in the unemployment rate to an average of 7.3% in 2020, from over 9% last year. Yet inflation is still forecast to be below target in 2020, at 1.7%, despite years of QE and negative interest rates. Indeed, the December forecast actually revised down the Bank’s projections for core inflation ( the headline rate excluding food and energy)  by 0.2 percentage points over the next two years.

In fact the ECB has significantly changed its forecast relationship between growth and inflation, as indeed have many Central banks. In their macro models, stronger GDP growth leads to lower unemployment  which in turn boosts wage inflation and ultimately price inflation via higher costs for firms, which are passed on to consumers. But, as is now well recognised,the relationship between unemployment and wage inflation has changed and the ECB is now adjusting its forecasts to reflect that fact. Two years ago, for example, an unemployment rate of 10% was expected to generate a 2.1% rise in wages but in the latest forecast wage inflation in 2019 is projected to be below 2% despite an unemployment rate as low as 7.8%.

So stronger growth. per se, is no longer  a sufficient condition for a meaningful acceleration in price inflation in the Staff forecasts, with the path of inflation strongly influenced by the exchange rate ( with a quick pass through to import prices ) and the oil price ( energy accounts for about 10% of the CPI). Oil prices in the current forecast are expected to decline modestly over the next few years (based on the futures market) to $57 a barrel by 2020, but if they fell further, to say $50, annual inflation would be 0.2% lower in 2019 and 2020. On the exchange rate, the euro/dollar is forecast to be broadly unchanged at $1.17 but if it appreciated to , say,  $1.35 over the next few years it would reduce the forecast CPI  in 2020 by  0.6 percentage points.

The ECB’s forecasts could well be wrong, of course, and  inflation may pick up by more than expected but they highlight the risk of what could be a huge policy dilemma later this year.The Bank probably wants to call a halt to asset purchases for a variety of reasons but what if the euro does indeed appreciate and oil prices decline, so leading to lower forecast inflation? Awkward for a Bank that has argued that QE is crucial in getting inflation back up to target.

What next for the ECB?

The ECB faces some tricky policy decisions  and judging by the minutes of the last meeting the Governing Council has no clear view on how to proceed. The euro zone economy has surprised to the upside this year, bank credit across the zone is  growing again, the redenomination risk in sovereign bond markets has long gone and the unemployment rate has fallen to 9.1% from  a peak of over 12% , all of which  might  argue for a change to policies born in a crisis environment or adopted when deflation was perceived as a real danger.

Yet the ECB”s (self-imposed) goal remains elusive- inflation is not ‘close to but below 2%’ and according to the current staff forecast that will remain the case for some time, with an average of 1.5% projected for 2019. Indeed, according to the minutes, some council members questioned whether the staff had used an appropriate pass-through rate from the euro’s recent appreciation and hence wondered if the inflation forecast was actually too high.

The minutes also revealed ‘discomfort widely expressed’ about the length of time inflation had been and was expected to remain below target, and that ‘a very substantial degree of monetary policy accommodation was still needed for inflation to converge sustainably to levels in line with the Governing Council’s aim’, which would imply that we are unlikely to see a substantial policy shift in the near trem. Indeed, ‘any reassessment of the monetary policy stance should proceed in a very gradual and cautious manner‘.

So what are the options?. Policy as it stands includes the purchase of €60bn assets a month until the end of December this year ‘or beyond, if necessary‘. The minutes would indicate an abrupt halt in  a few months is out of the question but there are logistical issues in a number of countries, given  the current 33% issuer limit on sovereign bonds. Consequently, the market is anticipating some form of ‘tapering’, and the minutes discussed the merits of continuing to buy for  a longer period but at a slower monthly pace against a higher monthly volume over a shorter time frame.

The former is perhaps more likely, as it better ties in with another strand of policy, a commitment to keep interest rates at current levels  for an extended period and ‘well past the horizon of the net asset purchases’. This explicit linking of forward guidance on rates to QE argues for extending the latter for a longer period if the ECB wants to influence rate expectations and that might indeed have an additional impact, this time on the exchange rate. We know the Bank is concerned about the currency’s appreciation, and if one rules out explicitly talking it down one lever left is to convince markets that rates will stay lower for longer.

The ECB will also no doubt emphasise that it intends to keep reinvesting the proceeds of maturing assets but the net asset decision will be key, and lower for longer may well be the mantra that decides the latter.

 

ECB caught between strong growth and weak inflation

Longer term euro interest rates have moved higher over the past few weeks as the market starts to adjust to what it perceives as an imminent change in monetary policy from the ECB. 10-year German bond yields are trading at over 0.5%, which is still extraordinarly low but compares with a yield of only 0.25% at end-June, so the speed of the move has surprised. A  ‘reflation’ reference by Draghi was the initial  catalyst ( although later played down by the ECB)  and the pace of economic activity has  certainly picked up this year but the problem for the hawks in the Governing Council is that inflation remains stubbornly below target (1.3% in June), with the core rate still remarkably low (1.1%).

GDP in the Euro area  (EA) grew by 0.6% in the first quarter and  strong  survey readings  (the IFO in Germany is currently at  a record high) imply a similar if not stronger figure for q2. On that basis it now seems likely that annual growth in the  EA may emerge at 2.1% or 2.2% this year and hence above the 1.9%  projected in the June  ECB staff forecast. There have only been two previous tightening cycles by the Bank, and the IFO is currently well above the level that has previously triggered higher rates, but , to date, the pick up in economic activity has not put any material upward pressure on prices.

The persistence of low inflation , not just in the EA  but across  other developed economies, notably the US, has prompted a lot of analysis.What is striking is the behaviour of wages, as they have not responded to tightening labour markets in the expected way. That relationship is generally known as the Phillips curve, and the evidence shows that the curve is now much flatter than in the past i.e.  a given fall in unemployment has very little impact on wages. So, for example, EA unemployment has fallen from 12.1% to the current 9.3% but wage inflation in q1 was only 1.4% and averaged 1.5% in 2016.

A range of factors have been put forward for this limp growth is wages; low price inflation, the decline of trade unions, globalisation, the growth of self employment and changes in the structure of the jobs market. Many of these factors are structural and if so, the acceleration in wage inflation expected by the ECB over the next few years may not materialise, despite stronger GDP growth.

The ECB also now tends to emphasise core inflation more than it did under the previous President, but the inflation target is set in terms of the headline rate, and most research shows that to be strongly influenced in the shorter term by commodity prices and the exchange rate. Consequently, the recent fall in oil prices and the appreciation of the euro ( up 8% against the US dollar in the past three months), unless reversed, would normally prompt a further downward revision  in the the next ECB inflation forecast in September.The June forecast itself reduced the inflation projection over the next three years by a cumulative 0.6 percentage points, largely reflecting weaker oil prices. Another point worth noting is that credit growth, although stronger than last year, is still anaemic, a factor referred to in the latest ECB minutes.

So what is the market expecting? It would be difficult for the ECB to claim that there are upside risks to inflation but having stated that the risks of deflation have effectively disappeared the Bank may tweak it guidance on asset purchases, which currently states that ‘we stand  ready to increase our asset purchase programme in terms of size and/or duration‘. In reality, the scope to increase QE is anyway constrained, as in a number of cases the Bank is at or close to the 33% issuer  limit in government bonds. However, the market does not expect an immediate halt to buying by the end of the year, rather a  gradual tapering of the monthly total into 2018.

Yet the ECB would find itself in a difficult situation if inflation fell further over the next few months, as it has argued that QE has been instrumental in boosting the price level and that ‘ a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term’. The Fed  also faces low inflation but can point to its dual mandate ( stable prices and full employment ) to justify tightening,  but the ECB does not have that luxury.

Stronger euro and weaker oil bad news for ECB hawks

Last December the euro briefly traded below 1.04 against the US dollar and few forecasters envisaged a short term recovery, with a number calling for parity against the greenback. In the event the euro has appreciated, with the past two months seeing a notable rally, taking the single currency above $1.12. The consensus has also shifted, with many abandoning bearish calls in favour of further euro appreciation. Speculative positioning  has also tilted decisively, with the market now running modestly long the euro/dollar for the first time in over three years.

One factor driving the euro is the economic data, which has generally surprised to the upside,  in turn prompting analysts to revise up their GDP projections. As a consequence many now expect the ECB to shift its policy stance, moving initially towards less dovish rhetoric before changing its forward guidance, although a rise in the deposit rate is not fully priced in until the latter part of 2018. In contrast, the US data has tended to surprise to the downside and the market, which was effectively pricing in two further rate hikes in the US this year, is now much less confident about the second ( although  a rise this month is still seen as highly likely)

In its  Staff forecast in March the ECB projected inflation at 1.7% in 2019, predicated on a euro/dollar rate of $1.07 over the forecast horizon. The exchange rate is seen to have a significant impact on prices in the EA and if the next forecast ( due later this week) used a rate of $1.12 that , all else equal, may push the inflation forecast for 2019 down by as much as 0.2 percentage points.

Moreover, the March forecast assumed an oil price around $56 over the next few years, and that now looks too high, given developments of late , with  Brent crude prices falling to around $50 on market concerns that the OPEC cuts have not been sufficient to make an appreciable dent in the unusually high level of crude stocks. Again, a lower oil price projection, say around $50, would shave up to another 0.2 percentage points off the inflation projection.

Of course the Staff may revise up some other components ( wage growth for example) to avoid having to lower the inflation outlook, and one sometimes wonders if the forecast drives ECB policy or the other way round, but on the face of it the combination of weaker oil and a stronger currency should have a disinflationary impact.

 

Euro rate rise expectations overdone

Just over a year ago the ECB cut its main refinancing rate to zero and its deposit rate to -0.4%, having first shifted the latter into negative territory in June 2014. As a result money market rates have also been negative for some time while longer dated  rates only turn positive at a maturity above 3 years. Yet March saw a change in the market view with regard to the ECB’s monetary policy and the possible timing of an interest rate rise, reflecting  both incoming data and  what were perceived as less dovish comments from Frankfurt.

The  euro composite PMI has  certainly continued to strengthen, reaching a six-year high in March,  and points to 0.6% rise in GDP in the first quarter given the past relationship between the two series, with the prospect of even stronger growth in q2. That, in turn, would point to a significant  upward revison to the current consensus growth  forecast for 2017 of 1.7%. Headline inflation also surprised to the upside, reaching 2% in February,  slighly above the ECB’s target.

The market also reacted to President Draghi’s comments that the ‘risks  of deflation have largely disappeared‘. The Governing Council still expects rates to remain ‘at present or lower levels for an extended period’  but Draghi also said that there was a ‘cursory’ discussion  at the March policy meeting about removing the prospect of a further rate cut while also stating that no Council member favoured any additional long term lending to the banking system . The market responded by giving a much higher probability  of a 0.1% rise in the deposit rate  this year and certainly by mid-2018.

The  ECB later let it be known that it felt the reaction excessive relative to the message it was seeking to deliver and rate rise expectations have been pared back somewhat, with a rise of 0.05% priced in by March 2018. The data has also been less suppotive and indeed worrisome for the ECB. The flash estimate for March inflation was much lower than expected, at 1.5%, and if one excludes food and energy the rate fell back to cycle low of 0.7%. Moreover, the modest uptick in credit growth that had been apparent appears to have stalled, with the annual rise in loans to the private sector easing in February, to 2.3%. These figures  impacted the euro, which is now trading back at $1.065 having spiked to over $1.08. The ECB also puts some store on the 5 yr 5 yr inflation swap as a measure of inflation expectations ( albeit less so now than in the past) and that has fallen back below 1.6%.

Some claim the March inflation data owes a lot to the timing of Easter ( in March last year ) and that there will be a seasonal rebound in April, including the core measures.  Unemployment in the euro area is also falling steadily, which might be expected to push up wage inflation ( although the latter has continually disappointed  forecasters) and that view is reflected in ECB projections, which envisage core inflation picking up to average 1.8% in 2019.

On market rates themselves, the level of excess liquidity ensures that short rates do not stray too far from the deposit rate , which is -0.4%. That excess, which tops €1,500bn, is the amount the ECB is pumping into the banking system, via QE and the TLTRO, over and above the liquidity  banks need to meet normal requirements. The Governing Council hopes this will be used to boost bank lending but so far the impact is limited, and one wonders what the ECB would do if credit growth slows in a material way. That issue may not arise but unless core inflation picks up appreciably any rate rise speculation is premature.

 

Can the ECB do any more?

Inflation in the euro area has been below 2% now for over three and a half years, and the ECB is currently pulling four policy levers in an attempt to get inflation back up to its target level. The first is forward guidance, adopted  by the Governing Council in mid-2013, designed to convince the market that rates will stay lower for longer. The latest wording to that effect states that ‘we continue to expect [rates] to remain at present or lower levels for an extended period of time’ which also flags the possibility of further easing.

In the past the ECB has used official interest rates as its main policy instrument and they are now at historically low levels; the refinancing rate is zero while the deposit rate has been cut to -0.4%. Money market rates are also  negative , including 12-month euribor. Forward rates imply that the market does not expect any upward move in official rates till 2019.

Credit in the euro zone is largely driven by the banking sector ( unlike the US, for example)  and the ECB has also introduced additional measures to boost bank lending , including offering banks long term loans at very low rates. The latest variant (TLTRO II) offers loans up to four years at a zero rate, and banks can reduce the rate paid into negative territory depending on the growth of their loan book. So the ECB would effectively be paying banks to take funds.

Bank lending to the private sector has picked up but is still very weak by historical standards ( the annual increase is currently 1.7%) and so the ECB has sought to influence spending more directly by its asset purchase programme, the fourth policy instrument currently at play. The current plan is to purchase €80bn a month ‘until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim

Inflation is currently 0.4% and the ECB’s staff forecast envisages a gradual acceleration to an average 1.6% in 2018. The consensus market view is that further monetary easing is a virtual certainty, although there is some disagreement about the form that might take. It is noticeable that the Governing Council is now expressing more concern about the profitability of the banking system (at least in the minutes of recent meetings) and fewer analysts now expect a further rate reduction in either the refinancing rate or the deposit rate. It is early days yet for the TRLTRO so any change there is unlikely and so we are left with possible tweaks to QE, including a tapering, although, again, there are a variety of views. Some believe that the ECB may broaden the universe of assets purchased, but in reality that means buying bank debt and/or equities, which may be acceptable for the Bank of Japan but is  highly unlikely , one would think , given the ECB’s constitutional  and operational constraints.

That leaves changes to the current government bond programme, and a majority of analyts believe that the scheme will be extended beyond March, for 6 months or longer. That is not without its problems, however, as in some cases the ECB is at or close to the current 33% issue and issuer limits ( including Ireland) and at various points of late almost half  the available bonds have been trading below zero, with a smaller proportion below -0.4% in yield. A decision to leave the deposit rate unchanged would presumably preclude the latter  and a decision to up the issue and issuer  limits  could potentially give the ECB the main role in any default proceedings, an awkward position for a bank regulator. At the moment the bond purchases are also constrained by the need to adhere to the capital key ( purchases are broadly proportional to each country’s weighting in the ECB’s capital) and again a decision to abandon this may prompt opposition fror the ‘German school’ within the Governing council.

What we do know is that various committess have been set up within the ECB to tease out these matters and examine how QE could be extended if required, but the bigger issue is whether the ECB is at or near the end of its monetary policy cycle. The December Staff forecasts will be crucial and it is worth noting that oil prices are  now higher , which of itself could push the 2018 inflation forecasts to around 2%. The Council also believes its policies have had a significant effect already are are still working through the system. QE has to end at some point, one would think, and the main issue now  is whether it will be in five months or ten.

Draghi as Sisyphus

Inflation in the euro zone has been below 2% for three and a half years now  and under 1% for almost two years, with the latest figure for August at 0.2%. Many people would think this a good thing in a period of very modest wage growth, as it supports real incomes, but it is a failure for the ECB , as its goal is price stability, which it defines as inflation  close to but below 2%. Very low inflation risks deflation in the Bank’s view and although the inflation trend is heavily influenced by weak commodity prices core measures are also weak: excluding food and energy,  inflation was 0.8% in August, indicating very little price pressures.

The ECB was slower than other Central Banks in cutting interest rates but the main refinancing rate is now at zero alongside a negative deposit rate of -0.4%, all designed to encourage banks to lend into the real economy. That approach reflects the importance of banks in the EA as the main providers of credit and the ECB has recently gone further down that particular road, with its  latest TLTRO scheme, allowing participating banks  to access  four-year funds at an interest rate which could fall to the -0.4% deposit rate depending  on lending growth. In other words the ECB could end up effectively paying some banks to lend money.

The ECB also decided to by-pass the banking route by embracing QE, with the purchase of government and corporate bonds designed to push down longer term rates. To date , some €1,165bn assets have been purchased, including over €940bn in government bonds, with the programme currently projected to run until March 2017.

Has any of this worked? Growth in the EA is averaging  around 0.4% per quarter, hardly stellar, but sufficient to put downward pressure on the unemployment rate, which has fallen to 10.1% from a peak over 12%. Bank credit has also started to rise, from a very weak base, with  lending to the private sector growing at an annual 1.7% rate in July and the ECB has been keen to point out that the cost of funds for EA banks in general has fallen steadily as a result of monetary policy decisions.

Yet credit growth is still contracting in many countries, including Ireland, despite ample liquidity. Indeed, data from the Central Bank here shows that in July deposits in Irish banks exceeded loans, a far cry from the 190% loan to deposit ratio seen pre-crisis. This highlights that in some countries deleveraging is still a dominant force and there are other factors at work, including capital issues for some banks, the scale of non-performing loans and the appetite from lending institutions to take on risk.

Negative rates are also an issue, in that they are putting downward pressure on net interest margins; banks are reluctant to cut deposit rates below zero but many of their loans are linked to market rates, which are falling. Initially the ECB was loathe to accept this point, arguing that higher loan growth would be an offset, but in the  minutes of the last Council meeting there was concern expressed  about the profitability of EA banks and their low stock market valuations, increasing the cost of capital for banks and hence reducing lending.

These concerns may dissuade the ECB from further cuts in the deposit rate and they also face problems with QE, in that the universe of government bonds available for purchase is shrinking, and in some cases the 33% issuer limit is likely to become a binding constraint- that will be the case in Ireland, for example. The ECB could change that limit or extend its purchase of corporate debt, although the latter already moves the Bank into allocating credit directly, which may make some Council members uncomfortable as well as stretching its mandate..

The bigger question is whether all this is having any impact on inflation and the answer would appear to be in the negative. Rather than increasing the bet, the ECB might reconsider its whole approach, with a growing  number of policymakers across the globe examining the case for more expansionary fiscal policy. On that point it was notable that the Fiscal theory of the Price Level got an airing at the recent Jackson Hole gathering, with a paper delivered by Princeton’s Christopher Sims, who is closely associate with that approach. The theory is that the price level is influenced by fiscal policy as  well as monetary policy, and argues that low interest rates  can be deflationary , in that they reduce debt service for governments and unless offset by higher spending or tax reductions will result in contractionary fiscal policy.

Generating inflation in the current environment requires much more expansionary fiscal policy, it is argued, and we may indeed end up with a changed fiscal approach in some countries, including the UK, albeit for different reasons. That appears very unlikely in the EA however, and President Draghi may end up like the legendary Greek king, doomed to push a boulder up the hill only to see it always roll back.

 

 

Negative Deposit rate hitting profitability of euro banks.

The ECB first cut its deposit rate to negative territory in June 2014, to -0.1%, and reduced it again late that year, to -0.2%, with a third cut taking it to -0.3% in December 2015. A further reduction was announced last month, to -0.4%, and since then criticism of the move has intensified, most notably of late from the German Finance Minister, concerned at the low return for savers.  Low and negative bond yields are putting pressure on insurance companies with products offering a guaranteed return and  the ECB’s deposit rate is particularly irksome for  the hundreds of small savings banks across the Federal Republic, given that retail deposit rates cannot fall below zero.

That squeeze on margins is not an exclusive German phenomenon, of course, and any banking system with a high dependency on retail deposits will be affected. Ironically, perhaps, banks in general have been urged to reduce their dependence on  the wholesale markets , and new Basel III rules on liquidity and funding also push banks towards deposits.

The ECB has recently responded to the criticism  by arguing that any squeeze on net interest margin  can be more than offset by higher loan growth, which the policy is designed to stimulate, and the capital gains resulting from the fall in bond yields. In that context the results of the latest  ECB Bank Lending Survey (BLS) for April is instructive, as it includes a number of ad hoc questions regarding the impact of non-standard monetary policy, including the effect of  the  negative  deposit rate. Not one  bank felt the deposit rate had a positive impact on their net interest income, with 63% stating a negative impact and another 18% a very negative effect, giving a net negative figure of 81%. Asked about the next six months, the net negative figure climbed to 85%. The vast majority of banks had seen no impact on loan volumes, although there was a small net positive, but this was offset by the negative impact on margins, so reducing overall income.

The survey also asked respondents about the impact of the ECB’s asset purchase programme, and again the results are unlikely to raise too much cheer in Frankfurt. A  small net number of banks (4%) had sold sovereign bonds as a result of QE and those experiencing capital gains in general  on assets for sales was a net positive 12% but that benefit was also more than offset by the net interest margin impact, with a net 27% seeing a fall in NIM. The result was that only 9% of banks had seen profitability rise as a result of QE, with 28% experiencing a profit fall, leaving a net decline percentage of 19%.

On the positive side QE was seen to have  improved the liquidity position of banks and  access to financing, notably via covered bonds, and the ECB has of late highlighted these metrics as a sign that  non-standard measures are working. Credit to the private sector is also finally growing again, albeit by an annual 0.9% , but for the moment at least the evidence supports the view that negative rates, in particular, are having a detrimental  effect on bank profits. It remains to be seen how that will change when the ECB’s long term loan scheme comes on stream.

 

 

 

The ECB’s Scattergun

The provision of credit in the Euro Area (EA) is largely delivered through the banking system, in contrast to the US, where capital markets are the main source of  loans. That explains, to some degree, why the ECB sought to flood the banking sector with liquidity following the financial crash in 2008, as opposed to seeking to influence the real economy more directly via the purchase of assets (QE). The Bank has  subsequently travelled a long way in its quest to boost economic activity  and is now utilizing a plethora of instruments in an attempt to hit its inflation target , although this scattergun approach may yield further disappointment.

In June 2014 the ECB was still of a mind that bank funding costs were the problem and announced a Targeted Long Term Refinancing Operation (TLTRO). Banks could borrow up to 7% of their existing loan book (defined as  lending to the non-financial private sector excluding mortgages) in two tranches, in September and December, at a cost equal to the refinancing rate (at that time 0.15%) plus 10 basis points. Banks could borrow more in subsequent quarterly tranches if their lending grew above stated benchmarks, with all lending to be repaid by September 2018.. In the event the take-up was disappointing, amounting to €212bn in the first two tranches , rising to a cumulative €418bn by end-2015, with the take-up in December just €18bn. This compares with total outstanding loans to the private sector of €10,600bn. The funding could not be used for mortgage lending and banks were no doubt influenced by the fact that loans had to be repaid early (by June 2016) if the benchmarks were not being met.

The ECB effectively accepted that the first TLTRO was not a success by announcing TLTRO II last week,allowing banks to repay early existing loans under the first scheme to encourage a switch into the new variant. This one  is designed to boost ‘lending’ as opposed to ‘lending to the real economy’ and there does not appear to be any restrictions. The scheme will start in June, with four quarterly tranches up to March 2017, and loans mature in four years from the time of origination, Banks this time can borrow up to 30% of their non-mortgage loan book at the refinancing rate , which is currently zero. Moreover, banks that are growing their loan book can borrow at a lower rate, down to the deposit rate, which is currently -0.4%. The pool of existing loans amounts to €5,600bn so in theory the amount of TLTRO borrowing could be substantial, with a 60% take-up implying a figure of €1,000bn.

So the ECB has sought to offset the impact of a negative deposit rate on the profitability of the banking system by allowing banks to borrow at that rate, or at least some of them. But is weak lending a function of funding costs?. The answer is probably no, at least for many banks; market rates have tumbled, allowing banks to borrow at very low rates anyway, without tying up collateral for years at the ECB, with capital , profitability and risk aversion the key issues on the supply side of the credit market. Others would argue that the demand for credit is weak anyway, given the uncertain economic outlook, and that the ECB’s decision to cut the deposit rate deeper into negative territory reinforces that uncertainty rather than assuaging it. Deleveraging is also a factor, particularly in Ireland, with many households and firms preferring to repay rather than add to debt.

The ECB has also partially undermined the rationale for the TLTRO by announcing the decision to extend its asset purchase scheme to corporate bonds . This will presumably encourage firms to issue debt and so disintermediate the banking system. Purchases will only include investment grade debt. which also implies that many corporates in the periphery of the euro zone will be excluded, with bank borrowing their only option. So bank lending to low risk corporates may fall, raising the risk profile of any remaining bank lending.

The ECB may also have hoped that’s this suite of measures would help to push the euro down, but that has not transpired, at least for the moment, partly due to  Mario Draghi’s comment that  ‘we don’t anticipate that it will be necessary to reduce rates further’. In that context it is interesting that Peter Praet, a member of the Executive Board, has subsequently sought to emphasize that we are not yet at the lower bound on rates, an indication that the Bank was not happy that the euro appreciated post- conference.