The ECB has managed to tighten monetary policy.

The ECB had flagged that its September meeting would deliver further monetary easing but it is testimony to the difficulty in managing market expectations that the net result is that policy is now actually tighter . That may change,of course, depending on how events unfold over the coming months but as it stands market rates have risen, as has the currency and short term bond yields, and excess liquidity in the market  has  actually declined.

Perhaps the most striking change announced by President Draghi was on forward guidance, with the pledge to keep rates at the current level or lower now no longer time dependent but open ended till the inflation target is achieved.The Bank had also spent most of the past five years denying that negative rates were having a materially adverse effect on the banking system but changed tack, with the introduction of a tiering system on deposit rates. Banks are required to maintain a given level of required reserves , currently €132bn, and these are remunerated at zero percent, the main refi rate. Excess liquidity, which stands at almost €1,800bn , is paid at the deposit rate, which at -0.4% cost banks over €7bn a year. The change now means that banks can hold almost €800bn at the zero rate, but still leaving around €1,100bn in excess,  now remunerated at -0.5% i.e. a cost of €5.5bn.

Some relief then for banks ,albeit one that was below market expectations, but the ECB also eased the terms on its latest long term loans package for EA banks (TLTRO III), which is now for up to three years at a rate equal to the main refi rate over the period, which is likely to be zero. Indeed, as with the other TLTRO’s, banks that grow their eligible lending by over 2.5% by end-March 2021 will pay the deposit rate, currently -0.5%. From an Irish perspective it should be noted that eligible loans exclude mortgages, which are the dominant lending for domestic banks.

The ECB also announced that QE will recommence  in November at  €20bn per month, with no set end-date, although it is likely the 33% limit would be hit in many countries after a year or so. The market reaction to all this may change when QE kicks in and when we have seen a number of TLTRO’s but to date policy is tighter than before the meeting; 3-month euribor for December is trading at -0.42%, from -0.54%, while the figure for December 2020 is -0.5% from -0.62%. The outlook for fixed rate mortgages has also changed as  5 year swap rates have also moved higher, to -0.35% from around -0.5% a few weeks ago.

The euro exchage rate, as measured by the effective or trade weighted index, has also appreciated, which one doubts was a policy aim, while short term bond yields have actually risen;  the German 2-year was -0.81% and is now -0.70% with the Irish equivalent rising to -0.49% from -0.64%. Banks are the main buyers of this debt and it is less attractive because they can now hold more reserves at a zero rate.

It’s early days, but the first TLTRO 111 actually reduced liquidity. Banks had borrowed €740bn under the previous scheme which with early repayment had fallen to €692bn, with another €32bn due for repayment next week. The take up of today’s first TLTRO III was only €3.4bn , implying a net drain of €29bn. Banks have had little time to prepare and no doubt the take up will improve but it is still a remarkable result.

The market had clearly priced in a lot from the ECB but one doubts that the Governing Council will be pleased by the result, an effective  monetary tightening. For prospective  Irish mortgage borrowers the result is also likely to mean less downward pressure on rates.

ECB rate cuts and Tiering

The current 3-month euribor rate is -0.32% and the market is now firmly expecting lower  ECB rates in the near term, with a 10bp cut priced in over the next few months and a return to a positive figure not expected till the end of 2023. A combination of weaker economic data (Germany may well have contracted in the second quarter), a fall back in inflation and more dovish rhetoric from Draghi and others has convinced the market that further monetary easing is  now highly likely, as opposed to the prospect of the modest tightening signalled by the Governing Council last year.

Market measures of  Euro Area (EA) inflation expectations have also plunged , raising doubts as to whether investors have much faith in the ECB’s ability to push inflation up to the target, and a new research paper from the Bank admitted that their standard models cannot explain why inflation has undershot their forecasts of late. Nonetheless the Governing Council insists that it still has the policy instruments required. A resumption of QE is possible but the market focus has been on  rate cuts, as that would also put downward pressure on the currency,

Which rate to cut?  The refi rate is currently zero so a reduction there would take it into negative territory and would certainly have an impact in Ireland- about 40% of existing mortage holders here are on tracker rates , averaging around 1%, so they would immediately benefit. However the ECB’s deposit rate, at -0.4%, is more important in driving money market rates and a cut is more likely to emerge there. Banks in the EA have to hold reserves, determined largely by the volume of customer deposits held, but for a long time now Banks across the zone have held a massive amount of excess liquidity which in the aggregate now amounts to around €1,900bn and puts downward pressure on money market rates. The ECB’s deposit rate acts as an effective floor, therefore, and a cut would lead to lower money market rates.

So a deposit rate cut of itself would not benefit Irish Tracker mortgage holders but would probably result in a fresh round of lower fixed rate mortgage offers and  a cut in existing standard variable rates. The ECB’s negative deposit rate has other consequences however, notably in terms of dampening the profitability of EA banks. This may not be a narrative that sits well in Ireland but the Governing Council appears to have become more concerned about the potential negative  impact on bank lending from the squeeze on net interest margins .

In fact the other countries that have introduced negative policy rates ( Japan, Switzerland, Denmark and Sweden)  have also included mechanisms to mitigate the adverse impact on commercial banks, essentially by allowing far more reserves to be remunerated at  a rate well above the deposit rate, a process known as Tiering. So for example, the ECB might allow  banks to hold a multiple of their reserve requirements, say  15 or 20 times, at the main refinancing rate  and so reduce the sums being  held at the (lower) deposit rate . Of course, the trick would be to still leave enough excess liquidity to drive money market rates lower and hence ease policy. Tiering would also persuade markets that rates could be lower for longer given that the potential damage to banks has been reduced.

The EA is different from the other countries noted above, however,in that excess liquidity is not evenly distributed across the EA. In fact most is held by banks in Germany, France and the Netherlands, with little held in the periphery, including Ireland. So Tiering would certainly boost the profits of core banks but may not have much impact on banks elsewhere, again including Ireland, Indeed, if banks can now hold far more reserves at a zero rate of interest it may prompt  some selling of government bonds currently paying a negative yield as this now becomes more painful. One size  certainly does not fit all  given the fragmentation of monetary policy across the EA  which  complicates the ECB’s task and no doubt explains why they are still ruminating on Tiering and how it might best work in the euro zone.