ECB rates lower for longer , Redux

Last June the ECB had grown more confident that the ongoing economic upturn would eventually result in inflation rising to nearer their target and at that month’s press conference announced that net asset purchases would ease and eventually cease at the end of the year. The Governing Council also made a significant change to its forward guidance on interest rates, which were now expected to remain at existing levels until ‘through the summer of 2019’, so replacing the previous ‘extended period’ with a more specific date for the first upward move.

At the time headline inflation had risen to 1.9%, with the ex-food and energy measure at 1.3%. Euro area growth was  expected to moderate only marginally, to 1.9% in 2019,  so the idea that the monetary policy stance was likely to change seemed plausible, and the markets duly priced in a 10bp increase in the deposit rate  for around September 2019.

Events did not materialise as the ECB expected, however. Growth in the EA slowed to 0.2% in the third quarter, with Germany and Italy both experiencing contractions, and the high frequency data implies that the fourth quarter figure could be weaker still. Consequently, the annual growth rate in q4 may well slow to 1.1% and initial indications from the January PMIs imply an annual figure of well below 1% in the first quarter, which makes the Bank’s 1.7% average growth forecast for 2019 look very optimistic. Inflation, too, has disappointed the ECB, with the ex food and energy rate seemingly anchored at 1.1%, with a core figure of 1%.

Some observers, including many on the Governing Council, had expected the slowdown that emerged in the second half of 2018 to be short-lived, particularly as the US economy is still growing strongly, albeit at a less dynamic pace than earlier in the past year. It now appears that others on the Council have become more concerned that the slowdown could be more protracted, and at the latest  ECB press conference the risks to the outlook were now deemed to be on the downside. Indeed, Draghi actually used the term ‘recession’, albeit giving it a low probability.

The ECB prefers to announce policy changes against the backdrop of a fresh set of forecasts, and so it chose to leave its current forward guidance on rates unchanged. That ‘summer of 2019’ guide now looks redundant, however, at least as far as the market is concerned, with the first rate rise now pushed out to around June 2020.  Longer term rates have also fallen, with 10-year Bund yields back below 0.2%, while  the cost to a commercial bank with a good  credit rating of borrowing three year money is -7 basis points. The euro has also faltered , and is trading back below 87 pence sterling. In fact Draghi acknowedged the divergence and implied that the Bank might well have to change its guidance at the March meeting, when of course it will have an updated set of staff forecasts.

There is still an enormous amount of excess liquidity in the euro system (around €1,800bn) but there is also some speculation that the ECB may announce a further TLTRO, which  was introduced in 2016 and is currently providing over €700bn in long term funding to euro banks at negative or zero rates, with a high uptake from  Italian and Spanish banks. For a number of reasons a substantial repayment may take place in June, prompting talk of an additional tranche to maintain high liquidity levels.

The economic outlook can change, of course, and a combination of a managed Brexit alongside an easing of trade tensions could spark an upturn in activity, hence prompting a change in rate expectations. The ECB also seem more concerned than in the past about the impact of negative rates on bank margins, another argument for moving rates up. Against that, the data flow remains relentlessly negative and there must be a risk that the ECB may have to change stance again, and adopt  additional measures to support activity. A generalised slowdown or recession would also probably prompt a big EU rethink on the fiscal side as monetary policy has taken most if not all of the strain in recent years.

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.

 

ECB -where to from here?

The ECB’s mandate is to deliver price stability, which the Bank itself initially defined as an annual inflation rate below 2%. Clearly there was no thought given to the risks of deflation with such an asymmetric target and the definition was subsequently tweaked to the current ‘below but close to 2%’. Euro area inflation fell below 2% in early 2013 and below 1% a year ago, with the latest ECB staff forecast projecting very low inflation for at least another two years. Moreover , the forecast was predicated on oil prices averaging $86 a barrel next year , which now looks high given that Brent is currently trading under $70.

There are ‘long and variable’ time lags with monetary policy, so one could argue that the current low inflation rate (the flash figure for November was 0.3%) reflects policy decisions made some time ago-remember the ECB actually tightened policy in 2011. Against that backdrop the recent press conference by ECB President Draghi was remarkable in many ways, not least because he had promised ‘immediate action’ on inflation in a speech in the latter part of November.

In the event the only change of note was in the language surrounding an expansion of the ECB’s balance sheet, which had been  ‘expected‘ to reach the level seen in early 2012 but now measures are ‘intended’ to achieve that level. That would entail an increase of about €1,000bn and clearly there is no agreement within the ECB to promote that as a target. Indeed, Draghi stated that there was not unanimity among the 6-member Executive Board on the announced change in wording, limited as it was.

Draghi had previously played down disagreements within the Governing Council but here seemed willing to place them out in the open, emphasising at one point that previous decisions had been taken  by majority. The obvious divisions  on further policy action made for an uncomfortable conference, however, with Draghi having to again indicate the need for more time to assess the situation despite more forecast downgrades and the blatant contradiction between that  approach and his earlier promise of ‘immediate action’

The upshot is that the Governing Council will reassess the situation ‘early next year’  including the size of the balance sheet. That will be affected by the existing bond buying programme (albeit the figure to date is just €22.5bn) and the outcome of the second targeted long term loan operation (the TLTRO). The latter saw a low uptake for the first tranche (€82bn) and there is a wide range of expectations with regard to the one upcoming, while there will be some offsetting downward pressure on the balance sheet via repayment of previous long term lending to the banks.

The euro rallied during the conference, which was attributed to disappointment about a  QE announcement, although that remains  the market’s general expectation. For others, including this writer, it remains less than a certainty that the ECB will eventually buy sovereign debt, and if it does it is not at all clear how much of an impact it will have on economic activity and inflation, leaving aside the impact it has already had on asset prices. A lot of uncertainty then, and one wonders if the next few months will see further resignations from the ECB Council given the fundamental disagreements on the next steps for monetary policy.