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.

 

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.

 

Negative repo rate at the ECB?

Economic growth in the euro area (EA) has been trundling along at 0.4% per quarter, which is probably above the zone’s potential rate but has not been strong enough to put much upward pressure on prices; core inflation is likely to average under 1% in 2015 and although some acceleration is generally expected  over the next few years it is forecast to be modest. The ECB’s inflation target is set in terms of headline inflation, which is currently lower still, at around zero, and again that is expected to pick up, reflecting the unwinding of the recent falls in commodity prices, but few if any forecast a rebound to 2% or above  by end-2017.

Low or zero inflation is supportive of real household incomes given the modest pace of wage growth ( 1.9% in the EA in q2  and 1.8% in Ireland) but the ECB is concerned about a prolonged period of below-target inflation, not least in terms of its own credibility. A more fundamental reason is that the real rate of interest (the nominal rate minus expected inflation) rises if expected  inflation falls, which all else equal will dampen investment spending in the economy.

Those concerns have prompted the Governing Council to contemplate further monetary easing, including additional non-standard measures such as an expansion of QE. The latter has  helped to boost asset prices in the EA and lowered corporate and bond yields, according to the ECB,  but it is less clear what impact that has on inflation- the effect on demand in the economy may not be large enough to put significant upward pressure on prices. QE is also deemed to weaken the currency and the euro certainly fell sharply in the early months of 2015, declining by 11% in effective terms to mid-April. According to   the ECB’s models, a 5% depreciation could boost inflation by up  to 0.5 percentage points so a currency depreciation would  seem to have the biggest impact on prices.

The euro reversed course over the summer months, however, rising by  7% in the four months to end-August , but has started to fall again and is currently about 7% below its value a year ago, albeit still 2.5% above its April lows. This also reflects  the expectation of rising rates in the US but the ECB may well seek to precipitate a much steeper fall in the effective exchange rate.

To that end the ECB has flagged a possible  cut in its Deposit rate, which for over a year has been at -0.2%. Despite that, deposits at the ECB, which had been very low at the beginning of the year, have risen strongly of late and currently stand at €187bn i.e. banks  would prefer to pay to leave cash at the ECB rather than lend it to their peers. Draghi had previously indicated that rates had reached the effective lower bound but that may be reassessed, not least because the deposit rate is at -0.75% in Switzerland and Sweden. Consequently, any  Deposit rate cut in early December may be larger than the modest change generally expected and a rate of -0.5% could be on the cards, which would also increase the universe of bonds eligible for QE.  Similarly, the refinancing rate could also move to zero or even marginally negative (the Swedish reo rate is -0.35%) if the ECB wants to surprise the markets and engineer a more substantial fall in the exchange rate.