ECB preview: further details in the (nervous) waiting room

This post details my expectations for Thursday’s ECB meeting, dissects the evolving macro-financial situation facing the ECB and provides some interest rate and FX views. The main points are:
•  Draghi will likely robustly defend the easing measures (recent German criticism), probably referencing the already-apparent positive impact on market corporate borrowing conditions.
•  He will also likely welcome the rise in inflation and oil price rebound, but probably reiterate that the risks to euro area growth remain on the downside.
•  He may well nuance his March comments apparently ruling out further rate cuts but step back from helicopter money being “a very interesting concept“.
•  We should hopefully get further details on the corporate sector purchase programme (CSPP) plus TLTRO II rebate payment practicalities.
ECB is likely on hold until the Autumn, as it gathers evidence on the efficacy of its easing measures (several of which don’t start until end-June). But the risks seem skewed to eventual further ECB easing (EONIA forwards already price more than a 40% chance by September, which may rise if Draghi backpeddles).
• The latest ECB bank lending survey isn’t that inspiring at a headline level and contains some worrying details about the (lack of/adverse) impacts of ECB policies.
• While real-side data have improved, fragilities remain with surveys indicating lack of momentum.
• Other financial market developments, especially the post-ECB fallback in inflation breakevens to close to record lows (with relationships with risk appetite and oil prices weakening), are less propitious.
• While ECB also won’t be thrilled with the euro’s recent strengthening, the TWI is up less than the main biletarals and the EURUSD and EURGBP rises are at least partly driven by foreign developments.
• My previous short EURJPY and EURSEK views (see here) have proved precient.  And they could extend further, given that their rationales remain valid (BoJ and Riksbank unable to match ECB easing, JPY and SEK both undervalued). But EURSEK could experience a short-term knee-jerk rise should the Riksbank suprise dovishly on Thursday.

Draghi to push back against criticism, watch out for rate cut comments and details of commercial bond purchases

Several of the new measures ECB announced on 10 March – TLTRO II’s, corporate sector purchase programme (CSPP) – have yet to be implemented.  So there’s no prospet of Draghi announcing anything new on Thursday.

But Draghi seems likely to robustly defend the March ECB easing measures, in light of recent German government criticism (although there have been more recent signs of rapprochement, see here) . So I’m expecting him to express confidence that the meaures are working – probably referencing the already-apparent improvement in market corporate borrowing conditions (see below) – but also remind markets that QE is effectively open-ended and won’t stop while ECB is missing its inflation target.

And we should hopefully also get some clarifucation on four key areas of ECB policy: further rate cuts, helicopter money, CSPP details, TLTRO II refund modalities.

First, Draghi’s view about potential further deposit rate cuts. Drahi’s comment at the March press conference (“we don’t anticipate that it will be necessary to reduce rates further“) apparently ruled out further ECB deposit rate cuts, despite the opening statement text leaving the door open, was a major shock to the market.  As I noted here, Draghi may have viewed the (throwaway) comment as innocuous, given that if they did anticiapte further easing but didn’t implement it they’d be planning on not achieving their objectives.  But the comment neverthless risked undermining the prospective credit easing bazooka by tightening financial market conditions. More recent Governing Council member comments, however, have seemed to place more weight on the more-dovish introductory statement comment. For example, on 8 April Belgian ECB member Smets commented  “Any further decision will obviously have to be thoroughly examined, but you cannot say that this door has been closed.”  This being the ECB, of course there have also been more hawkish comments from Weidmann and Nowoty (the Appendix below sets details the full range of recent ECB comments).

But should the opening statement text be maintained, as I expect, Draghi will undoubtedly be asked for clarification. I would then anticipate him probably reiterating his recent “The ECB has and will continue to do whatever is needed to comply with its mandate” comment i.e. nuancing his apparent March veto on further rate cuts (or even just straightforwardly saying “the market over-interpreted my comment”).  So overall his comments seem unlikely to push back on growing market expectations of further rate cuts – the Chart below illustrates that the (EONIA forward) market is already pricing a 45% chance of a rate cut by September, with that probability rising further by end-2016 and into Q1 2017. Indeed, should Draghi backpeddle (as I expect) the EONIA forward curve will likely fall further. That said, Draghi will also likely again stress that the ECB focus has shifted more towards credit easing, indicating that any move is likely to be fairly small (given already-elevated expectations).


Second, Draghi’s March comment that helicopter money is “a very interesting concept” sparked fierce debate/criticism in Germany, reinforcing existing scepticism about QE and negative rates.  Given that a range of less-controversial measures are available, I expect Draghi to repeat that the ECB is not looking into helicopter money at present and thereby hopefully ameliorate the controversy.

Third, we may get some further details on the corporate sector purchase programme (CSPP).  In March the line was that “Purchases under the new programme will start towards the end of the second quarter of this year….Further technical details on the CSPP will be announced in due course”.  The latter hasn’t happpened yet and while the details could theoretically wait until the 2 June ECB meeting, market participants would prefer to know earlier and a delay could give the impression of GC disagreements.  According to the ECB accounts (minutes) “The list of eligible assets under the CSPP would comprise investment-grade euro-denominated marketable debt instruments issued by euro area non-bank corporations, with the exact definition still to be specified. A starting point for the eligible universe under the CSPP would be bonds eligible under the Eurosystem collateral framework.” Market expectations seem to be that CSPP will ammount to around €5bn per month.

Fourth, there’s a need to clarify when EA banks will receive the rebate associated with exceeding the pretty-low lending benchmarks in the TLTRO II’s (i.e. “paying” the negative deposit rate rather than the repo rate) . If that subsidy to banks (“money for less than nothing”)  doesn’t somehow accrue during the four-year period, and instead ends up being paid at the end of it, the scheme would be far less attractive (there’s no restrictions on using the ECB liquidity to fund carry trades).

Real Economy: continued fragility

The ECB will likely have apreciated the rises in both headline and core inflation, to 0.0% and 1.0% resectively.  Draghi noted last month that “very low or even negative inflation rates are unavoidable over the next few months, as a result of movements in oil prices”. So the Governing Council is unlikely to be significantly influenced by continued low inflation outturns over the next few months.  But they’ll probably welcome the oil price rise in recent weeks, which hasn’t substantially reversed despite Sunday’s lack of agreement in Doha to freeze supply.

Superficially, the rise in the Citi economic surprise indicates that EA activity data have in recent weeks been less disapppointing than previously (see Chart). Indeed, the EA surprise index is back at a similar level to the US equivalent, and unlike the previous time the EA series is rising while the US one is falling.  But there are nevertheless signs of continued fragility.  The EA PMI’s have been weakening in recent months, with Markit commenting that “The euro-zone economy failed to show any significant gain in momentum…Sluggish growth is the result of lacklustre demand, accompanied by falling prices as firms compete at the expense of profit margins.” Industrial production has also been weakening, albeit erratically, and although corporate lending growth rates continue to edge up the 0.9% y/y figure is hardlly setting the world on fire.  But at least retail sales continue to grow steadily, and lending growth to housholds s also rising.

Slide2  Slide3

Credit conditions survey: not that inspiring, especially APP/negative rate impacts

The ECBs renewed focus on credit easing raised the importance of the latest ECB bank lending survey, which was conducted after the ECB’s March announcements (11-30 March).    So it’s positive that bank credit standards on loan to enterprises eased over the past three months (see Chart), driven mainly by competition but only a marginal impacts from reduced bank funding costs.  And such credit standards are expected to ease a little further over the next three months.  But the story is less positive on corporate credit demand, which over the past three months showed a slowdown due mainly to weaker demand for investment (capex) purposes (see Chart).  And expectations for enterprise credit demand over the next three months also continued softening.


But the responses to the additional questions on the impact of the ECB’s measures don’t paint a great picture, leading to some scepticism about the efficacy of policy (although the terms of the TLTRO II’s are generous):
• Most banks expect that the extra liquidity provided by the expanded asset purchase programme to basically have no impact on their behaviour i.e. loan-granting behaviour. Indeed, for loans to companies, fewer banks now say QE liquidity is helping their lending than did so in October.
• Fewer banks view say QE liquidity as supporting loans than in October, especially those to corporates (see Chart).
• Banks reported that negative deposit rate have reduced their profits (net interest income and loan margins) over the past six months (see Chart).
• That said, negative rates had a positive impact on lending volumes, especiallly to households.
• Banks’ acsess to debt-securities markets deteriorated, although access to securitization had improved.

Mixed messages from financial markets: ECB moderately concerned especially about breakevens

Overall ECB will be moderately-concerned with financial market developments subsequent to their 10 March announcements of further easing measures (skewed to credit easing rather than further rate cuts).

The most positive development from an ECB perspective is that the announced corporate bond purchase programme (CBPP) seems to have had the desired impact on corporate borrowing costs. In particular, EA corporate CDS premia and corporate bond spreads have both fallen in the wake of the ECB announcement (see Charts below), even though the ECB have yet to actually provide any firm purchase details. The impact on corporate CDS premia was rapid, with premia having subsequently been range-bound.  By contrast, EA corporate bond spreads have continued to edge down in the six weeks following the ECB announcement.  That said, the move thus far has only taken spreads back to around their levels six months ago.  Investment grade spreads have fallen most (see second chart below), consistent with the market expecting eventual ECB purchases to be concentrated in this less-risky part of the market than in high-yield corporate debt.


The ECB may also take some comfort from the recovery in EA equity prices, incuding bank stocks.  But that should be tempered by the fact that these boncebacks have lagged their US and UK equivalents (see Chart).


The ECB also probably won’t be jumping for joy about the bond maket reaction to their measures.  The positive is that 10-year bund yields are down around 8bp since the March ECB announcement, after rising on the day, consistent with my view in advance of the meeting (see here).  But that’s actually smaller than the 11bp fall in US Treasury yields.  And the chart below illustrates that Bunds and Treasuries have traded pretty closely over the past six weeks.  Of course, that’s not unusual in the international bond market, but it does question whether the ECB is getting any extra kick from their measures or if the bond market rally just reflects global economy concerns (pushing out Fed rate hike expectations). And the ECB will also be a bit concerned that the initial narrowing of peripeheral-bund spreads has subsequently unwound probably not helped by ongoing political uncertainties in Spain and Portugal.  Reassuringly, however, Greek spreads haven’t moved disproportionately despite the ongoing bailout saga.

Slide15  Slide16

But the ECB will likely be more considerably concerned about the fall in EA inflation breakevens despite their announcing measures which they deem subatantive. While the fall in 5y5y inflation breakevens is relatively small (only 10bp), the post-easing tendency looks downwards and the latest 1.40% is have not far from the end-February record low of 1.37%. And technical factors could kick in should that low-point be breached. Moreover, the ECB Governing Council have become increasingly worried about low inflation expectations becomming entrenched, thereby generating second-round effects on wage-setting behaviour and making it more difficult for the ECB to meet their inflation objective.


Moreover, the fall in EA inflation breakevens becomes more concerning given several ancillary developments.  First, the latest decline has occurred despite EA equities prices having recovered – breaking the previous close link between the two (which either reflects the role of investor risk appetite or of underlying growth prospects).  Second, EA inflation breakevens have fallen back despite oil prices having recovered from their previous lows (helped by some improvement of global growth prospects and (dashed) hopes for a supply freeze deal, see here).  Third, the EA breakevens’ recent downward tendency contrasts with the bounce in US 5y5y inflation breakevens (see second chart above).  All this suggests that something genuinely negative could be happening to EA inflation breakevens, despite fresh ECB easing, rather than it representing inflation risk premia effects.

That said, one relief for the ECB is that because EA nominal rates have also fallen, the decline in inflation breakevens hasn’t translated into a rise in real interest rates – which wouldn’t have been good for the fragile EA recovery.

The ECB probably also won’t be that pleased at the euro’s appreciation since the March ECB meeting. The initial impetus was Draghi’s strong hint that there would be no further deposit rate cuts (see here), which generated a 3%-plus intraday EURUSD whipsaw. But that EUR strength has extended over the subsequent six weeks (see Chart), such that EURUSD is cumulatively up 3.5%.  But the EUR TWI, which ECB care most about, is up somewhat less (only 1.2%). So the euro will be less of a concern to ECB than inflation breakevens, and hence probably won’t directly comment on it. After all the ECB focus has shifted away from generating EUR weakness via rate cuts towards supporting domestic demand via credit easing (TLTRO II and CSPP).


Indeed, the second above illustrates that the TWI’s post-ECB rise has been driven by strength versus USD and GBP, with other EUR bilaterals generally down.  And that seems to reflect the repricing of Fed rate hike expectations and growing Brexit/UK current account concerns (see here) as much as EA-specific factors (i.e. letting Draghi off the hook). That said, the Chart below illustrates that the 2016 link between EURUSD and ECB-Fed policy expectations is fairly broad rather than unbilical (it’s even looser for EURGBP, consistent with risk premia effects with Brexit etc concerns).  Indeed it’s also notable that EURUSD’s multi-month close link with 10-year Bund-Tresaury differentials weakened substantially after the March ECB meeting.


But the ECB may also take comfort from risk reversals indicating downside risks to EURJPY and, to a lesser extent, EURUSD (see Chart above).  While the former seems right (see next section) I’m less convinced about EURUSD given on-going Fed dovishness driven by international developments.  Conversely, risk reversals point to substantial upside risks to EURGBP and, to a substantially lesser extent, EURSEK.  The former seems right given that Brexit concerns are likely to become more impactful as the EU referendum approaches, unless the “remain” camp manages to achieve an unassailable lead in the error-prone polls (although this isn’t my favourite bilateral to short GBP against, see here). But I’d judge that EURSEK risks are actually to the downside (see next section).

How to trade it: remain short EURJPY and EURSEK (but potential near-term bounce)

My early-March view that short EURJPY and EURSEK positions were attractive around the March ECB meeting (see here) proved prescient, with the latter performing particularly well (see Chart above).  Underpinning those recommendations were the view that BoJ and Riksbank seemed likely to have difficulty in matching the extent of ECB easing (both policy committees are divided on further action), JPY’s strong safe haven role, Sweden’s stronger growth/inflation prospects and both JPY and SEK being undervalued (thereby raising accusations of competitive devaluations if they ease aggressively). Those arguments remain valid, suggesting that EURJPY and EURSEK downsides can extend further, although this seems likely to be a slow grind rather than anything sharp, especially as the risks seem skewed to Draghi nuancing his comment about further rate cust on Thursday.

The risk to the short EURSEK view is that the Riksbank may surprise dovishly on Thursday, despite recent stronger-than-expected Swedish inflation and inflation expectations, strong growth dynamics, the divided Riksbank and  deputy Governor Skingsley’s recent comment that “It may be time to take a longer-term view now resource utilisation in the Swedish economy is almost normal and the inflation trend is towards the target. In this type of situation it is not necessary to make monetary policy even more expansionary.”  But the recent 2.2% industry wage negotiation outturn will likely disappoint the Riksbank and they will likely want to avoid a sharp SEK appreciation which could undermine the recent progress on inflation. So a further extension to the Riksbank programme, which is due to expire at the end of June, seems possible and indeed there have been growing market expectations of this.

And that may well generate a knee-jerk EURSEK bounce, especially if Draghi sticks to his line about further rate cuts beign unlikely (not my expectation). But the pattern recent Riksbank easings, where the initial SEK weakness unwinds relatively quickly, seems likely to happen again.  The market knows that the Risbank ultimately neither has the need nor the means of matching the extent of ECB easing (the small Swedish government bond represents an important constraint). So further EURSEK downside seems likely over the coming months, especially since the risks seem skewed to further ECB rate cuts after they’ve had time to assess the impact of the already-announced measures.  Investors may prefer to await more attractive entry positions in the days after the Riksbank’s decision, although a near-term bounce is far from guarenteed.  The Riksbank may be subsequently be tempted to implement their previous threat to fall back on FX intervention to try and slow the SEK’s rise (they’ve been clear they don’t aim to influence SEK ) in order to secure rise in inflation. While this raises the chances of EURSEK downside being a steady grind, this possibility is reduced by the Riksbank’s likely reluctance to build large FX reserve positions (on which to subsequently make losses).


Appendix: Selected ECB comments on further policy action (rate cuts)

ECB Introductory statement (10 March):”expects the key ECB interest rates to remain at present or lower levels for an extended period of time“.
Draghi (10 March): “From today’s perspective, and taking into account the support of our measures to growth and inflation, we don’t anticipate that it will be necessary to reduce rates further. […] Does it mean that we can go as negative as we want without having any consequences on the banking system? The answer is no.”
Praet (17 March) “we have not reached the physical lower bound….our measures could be recalibrated…if new negative shocks should worsen the outlook or if financing conditions should not adjust in the direction and to the extent that is necessary to boost the economy and inflation.
Weidmann (23 March): “decisions overall went too far in my opinion and the comprehensive set of measures didn’t convince me….too early to determine with certainty whether this decline in the core rate will be temporary or lasting…we are handing monetary policy too many challenges”.
Slovak Governor (30 March):“further cuts bring a weaker effect. It’s more of a psychological tool. We can’t expect it to have much impact”.
Couere ( 30 March) “They know we will not take rates into absurdly negative territory…But we can never rule out further moves. That would not be credible anyway.”
Praet (4 April) “Without further decisive policy action, sized to a scale appropriate to arrest the process, a downward re-anchoring towards a lower inflation rate could not have been ruled out…..the need for a superior policy mix is no excuse for central banks to be passive when their mandates are under threat.”
Nuoy (4 April): ECB “is aware that the low-interest-rate environment is putting pressure on the profitability of European banks.”
Schaeuble (6 April): ECB policy “doesn’t have as beneficial an effect for Germany as for other countries,” which leads to “growing problems in legitimising European policy in Germany, and not just among the older generation.”
ECB accounts (minutes, 7 April): “On the one hand, a sharper rate cut could be considered, together with indications that the effective lower bound would have been reached for all practical purposes. On the other hand, the proposed limited rate cut could be judged as appropriate for now, given the current assessment, while it would also not rule out the possibility and prospect of further cuts if warranted by the outlook for price stability.”
Draghi (7 April): “The ECB has and will continue to do whatever is needed to comply with its mandate. Our decisions have also helped to maintain trust in the single currency. We have no shortage of tools available
Praet (7 March): “According to the staff assessment, our policy is contributing to raise euro area GDP by around 1.5% in the period 2015-18
Smets (8 April) “Any further decision will obviously have to be thoroughly examined, but you cannot say that this door has been closed.”• Villeroy de Galhau (10 April): “The ECB is not short of ammunition. Until we reach our inflation goal it will be legitimate to use every monetary policy tool. If necessary, we could intervene further.”
Mersch (11 April): extraordinary measures to spur growth may eventually show diminishing returns. QE program carries a “certain risk”
Constancio (13 April) “important to recall that there are clear limits to the use of negative deposit facility rates as a policy instrument….Overall, broadly counting all the effects that negative deposit facility rates have on banks’ profitability, the aggregate result comes up positive for the euro area as a whole…the full effects of these measures on macroeconomic conditions have yet to fully materialize.
Nowotny (13 April): important not to “over-dramatise” low euro-zone inflation because it should begin to rebound this summer.




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