The ECB today vindicated my arguments for an aggressive broad monetary policy easing: rate cuts, QE expansion and credit easing at very attractive rates exceeded market expectations but were more in line with my views (I’d hoped for a 20bp deposit rate cut, accompanied by tiering of interest rates, rather than the whole rate corridor falling 10bp). As I expected, the action was driven by lower inflation forecasts, with the 1.6% 2018 forecast pointing to potential further action while the detailed growth forecasts still look rose-tinted. But the party turned flat when Draghi implied that further rate cuts are currently off the table (markets ignored the caveat that things could change), with the initial market euphoria reversing. So the euro ended higher (with EURUSD experiencing a sharp 3%-plus intraday whipsaw), EA equities fell back (although bank equities performed better) and bund yields rose 5-8bp (although peripheral spreads fell actually fell), with the bond market reaction looking a bit inconsistent with “risk-off” dynamics. Those market moves are unfortunate given Draghi’s focus on loosening financial and monetary conditions and probably could have been avoided if Draghi had been more careful with his comments. But the ECB will likely see it as short-term market noise and anticipate their announced measures gradually working through banks and financial markets. So the key issue is whether the greater focus on credit easing, plus expanded QE, will yield positive results. The very attractive terms offered by the new TLTROs gives room for optimism, although the continued need for corporate deleveraging and EA/global uncertainties represent headwinds to investment/loan demand while the latter stages of the previous TLTRO disappointed. Draghi unsurpsingly stressed the positives and downplayed concerns about negative rates’ adverse impact on bank profits. And the QE acceleration should at the least forestall rises in bond yields and could well see peripheral spreads narrow further. But market scepticism about policy efficacy may be dificult to shift and helps account for the market reversal on Draghi’s rate cuts comments, although there’s also a whiff of over-reaction. Looser monetary policy just brings forward future demand: the market is well-aware of this limitation. So it’s going to be important to monitor market conditions, including the EA 5y5y inflation breakevens which thankfully didn’t plummet during today’s market volatility, plus (corporate) lending flows and spreads, in assessing whether the ECB’s bazooka has finally hit it’s target or whether the EA’s lack of structural reforms and absence of major fiscal support prove too strong headwinds. The ECB’s apparent move away from further rate cuts also suggests a lesser focus on EUR weakness, which has hitherto been an important transmission channel of ECB easing, causing them to push back against EUR strength. So investors hoping for euro weakness may have to rely more on foreign developments – next week’s FOMC meeting will be carefully watched (I suspect that Yellen won’t meet market hopes of ruling out a June rate hike). Although there’s also evidence of strong portfolio flows out of the EA, a euro-negative, this could change with the greater ECB focus on narrowing credit spreads rather than driving down risk-free rates.
ECB kitchen sink time, greater focus on credit easing, Draghi stressing the positive
The ECB’s announced mixture of general monetary policy easing and credit easing initially exceeded market expectations, with initial press headlines having a “shock and awe” flavour and markets rallying. In particular Draghi announced that the ECB GC had, by an “overwhelming majority” agreed the following measures:
(i) Cutting all three of its interest rates – the depo rate by 10bp to -0.4%, the main refi rate and the by 5bp to 0.0% the marginal lending rate by 5bp to 0.25%;
(ii) Enhanced forward guidance: Draghi’s opening statement noted that “the Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases.”
(iii) Raising monthly QE purchases by €20 to €80bn a month (with, as I expected, the end-date remaining unchanged at March-2017, by when ECB QE purchases should ammount to around 18% of EA GDP);
(iv) Including non-bank corporate bonds in QE purchases (albeit with details to be worked out and Draghi ducked the question);
(v) Raising the APP issue/issuer limit from 33% to 50% for supranational bonds (but not yet sovereigns);
(vi) Starting a fresh round of credit easing via a set of 4-year TLTRO’s, likely eventually involving the ECB paying banks to lend. In particular, the four new TLTROs will initially be financed at the refi rate (i.e. for free!) but will transition to the deposit rate (-0.4%!) if lending targets are met. Such subsidisation of bank lending aims to inject more momentum into corporate lending flows and get investment going (I’ve been concerned about the weakness of both since last summer). Draghi argued that such funding was particularly useful given large prospective bank bond redemptions and that the GC was optimistic given the TLTRO experience (even if my read is that this disappointeed in the latter stages as uncertain EA prospects crimped corporate loan demand).
Draghi was keen to big-up the measures announced, countering growing concerns about policy becomming ineffective: “It’s a fairly long list of measures, and each one of them is very significant and devised to have the maximum impact in boosting the economy and the return to price stability – we have shown we are not short of ammunition”. Constancio also tried to refute concerns that negative interest rates were hurting EA banks’ profits, although he and Draghi acknowledged that their evidence related to the aggregate EA banking sector and some banks (reliant on retail deposit funding or with mortgages indexed to market rates) would suffer more. Unsurprisngly Draghi came across as confident that the measures will work “the measures we took today are adequate to address the change in economic conditions that occurred since our last monetary policy meeting.” And he stressed that without the easing measures so far “The counterfactual would have been disastrous deflation.”
That said, there are several areas where the ECB could have gone further (see my preview) and might yet have to revisit:
(a) Tiering of interest rates, to offset the impact of more negative rates. Draghi spelt out that “The final decision on not having a tiering system, was not only the desire not to signal that we can go as low as we want, but also the complexity of the system….The Governing Council is increasingly aware of the complexity that this measure entails.” That comment, together with his view that further rate cuts were not in prospect, reversed the initial positive market reaction (see below).
(b) Shifting APP purchase allocations from being determined by the ECB capital key e.g. towards weighted market volumes, to allow more periphery purchases (politically difficult).
(c) Loosening the constraint that the APP can’t buy bonds with yields below the deposit rate (now -0.4%), to widens the pool of available securities (but expose the ECB to greater losses).
Staff forecasts less rose-tinted, ECB watching for second round effects
As I expected, the measures were motivated by reasonably-large downward revisions to the ECB staff inflation forecasts (see chart). The 2018 1.6% headline HICP forecast was at the upper end of my expectations, but still suggests that the bias is to further ECB measures being needed. And notably the core inflation and unit labour cost forecasts were also revised down, which is unusual and points to limited second-round effects. But Draghi stressed that the GC are alert to these: “While very low or even negative inflation rates are unavoidable over the next few months, as a result of movements in oil prices, it is crucial to avoid second-round effects by securing the return of inflation to levels below, but close to, 2% without undue delay. The Governing Council will continue to monitor very closely the evolution of the outlook for price stability over the period ahead.” The second chart below illustrates that the lower inflation forecasts were largely diven by the lower oil price (as I anticipated here) and a stronger euro: the ECB now anticipates EURUSD at 1.12 in 2017/18, up from 1.09 in December, with the TWI 5% higher.
Growth forecasts were also revised down, although by comparatively modest amounts: it is forecast to rise from 1.4% in 2016 to 1.7% in 2017 and 1.8% in 2018, albeit with downside risks. Weaker foreign prospects play a prominent role in the lower growth (see chart above). Draghi acknowledged that recent surveys had deteriorated and that the growth uptick was taking longer-than-expected to occur. But digging into the forecasts reveals some remaining rose-tinted elements: the consumption forecast is little changed and while both the investment and exports forecasts have been revised down a little, bit big picture they remain pretty strong in light of recent under-performance.
Mario skids the financial market cart with rates comment – but market over-reaction?
The main fly in the ointment of today’s ECB jamboree was that the initial positive market reactions on the kitchen sink easing (which initial bloomberg reports characterised as “shock and awe”) were reversed with Draghi off the cuff remark that “from today’s perspective, we don’t anticipate it will be necessary to reduce rates further.” Market took this as a strong steer that there will be no further rate cuts, buttressed by accompanying remarks that tiered rates were rejected because they didn’t want to signal that rates could keep declining and that the focus was shifting away from rate cuts and towards other unconventional policies plus credit easing. The financial market reaction was swift and notable with the initial risk on mood reversed:
(i) The initial 1%-plus EUR falls quickly reversed such that EURUSD ended up nearly 1.5% on the day (approaching 1.12, representing a 3%-plus intraday swing) with other major EUR crosses not far behind (see chart). Indeed, EUR rose by closer to 3% on the day against some of the riskier bilaterals such as ZAR. It’s also notable that EURUSD’s strength exceeded that implied by 10-year government bond differentials, representing a break from the close links in recent months. I’ve noted many times before that investors hoping for major EUR falls are likely to be frustrated as long as the EUR remains a “risk-off” currency, given it’s funding currency status in the wake of negative ECB rates, even if that status is fragile to continued EA economic underperformance. Moreover, the apparent move away from further rate cuts suggests a lesser ECB focus on euro weakness, which has hitherto been an important transmission channel of ECB policy and has been associated with the ECB to push back against euro strength. And, as mentioned above, the updated ECB forecasts incorporate a stronger euro. So investors hoping for euro weakness may have to rely more on foreign developments. That said, EPFR data show foreign fund managers withdrawing nearly $7.2bn from eurozone equity funds in the four weeks to 2 March (see here), reinforcing the significant net portfolio outflows from the EA, driven by EA residents buying foreign assets (predominantly foreign bonds) reported in the less-timely ECB data. But this could be set to change with the greater ECB focus on narrowing credit spreads rather than driving down risk-free rates and so needs to be monitored carefully.
(ii) Similarly, EA equity prices retraced their initial strong gains ending the day down around 1% and dragging down the FTSE. That said, the retracement in EA bank stocks was more limited and indeed ended the day with a small gain – probably helped by the TLTRO2 announcement – thereby continuing the rebound from the mid-February lows. But German commentators remain vocal about the adverse impact of negative rates on bank profits and there were reports that several banks petitioned the ECB against further rate cuts. As mentioned above, Draghi and Constancio argued that there has been no adverse impact on EA banks in aggregate but acknowedged some frailties.
(iii) Bund yields rose after initially falling on the ECB announcement – with 2-year and 10-year yields up 8bp and 5bp respectively. Such rises are hard to square with a “risk off” effect, so market moves are a little puzzling. But peripheral-bund spreads nevertheless continued narrowing, with Portguese yields actually falling on the day. Indeed, expanded QE purchases may see spreads narrow further.
(iv) One dog that hasn’t barked in today’s market volatility following Draghi’s rate comments is EA 5y5y breakevens. Rather they edged up a couple of basis points to continue the rebound over the past week which has seen it start to catch up with the oil price bounce. I’ve been arguing for months that the nascent de-anchoring of inflation expectations necessitated urgent and decisive ECB action (see here). And this is going to be one of the key indicators to watch going forward (along with lending flows) to determine whether the ECB bazooka has hit its target.
That said, markets may also have over-reacted a little to Draghi’s rate cut comments. Specifically, they don’t seem to have heard Draghi’s caveat that “new facts can change things” about rate cuts. Moreover, it’s almost definitional that the ECB shouldn’t currently expect to ease further – if they did then they should have eased more today i.e. they’d be admitting that they’d make a policy mistake. And, as discussed above, the Draghi’s opening statement strengthened the forward guidance on rates “expects the key ECB interest rates to remain at present or lower levels…well past the horizon of our net asset purchases.” So events could yet force the ECB’s hand, especially if TLTRO2 take-up disappoints (as the later stages of TLTRO did).
But you can also question why, given fragile market confidence in the ECB, Draghi felt compelled to make this comment which he surely should have realised wouldn’t be taken well by markets. So the new measures haven’t set off on the greatest footing and confidence effects are important when firing an easing bazooka. It would probably have been better if he’d adopted the standard central bank response of “it depends on how things evolve, but we’re confident that the measures will be impactful“. Hopefully not too much damage has been done!