We have often argued that it is the economy, not monetary policy, that matters most in a recovery. In early June, the European Central Bank (ECB) unveiled a ‘big bazooka plan’ to fight deflation risk in the eurozone. Have they done enough to convince markets?
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ECB “credit easing” package: all smoke but no fire?
In contrast to other central banks – such as the Federal Reserve – the ECB has a single primary objective of maintaining price stability and keeping inflation below, but close to, 2%. With the year-on-year inflation rate now at 0.5% (Figure 1), it did not come as a surprise that the ECB, in early June, finally acted to bring inflation closer to the target.
There was a small cut to the headline rate: the main refinancing rate was lowered from 25bps to 15bps. According to ECB President Mario Draghi, this represents the lower bound of interest rates – technical adjustments notwithstanding – and is likely to remain at this level for some time. The fixed-rate full-allotment procedure for the main refinancing operation (MRO) was extended until at least December 2016; a measure that will guard against any liquidity shortfalls and reinforce the forward guidance. The ECB deposit facility rate was also lowered from 0bps to a negative 10bps. This means that banks are, for the first time, charged a penalty when they park money with the ECB instead of lending it to customers. Overall, these changes imply that short-term eurozone rates will be forced into a corridor of between +15bps and -10bps.
On its own, the negative deposit rate could incentivise banks to trim their excess liquidity and, therefore, place upward pressure on short rates, pushing them towards the upper end of the corridor. The ECB recognised this and subsequently announced two measures that add longer-term sources of cheap liquidity into the system. First, the ECB will quit sterilising its securities market-programme (SMP) purchases, which will instantly add about €150bn of fresh liquidity. Second, preparatory work related to outright purchases of asset-backed securities has intensified, which could add long-term liquidity in the coming months. This will likely push rates lower – close to 0% and perhaps even negative.
While this change in eurozone short rates appears marginal, the move could be significant as it may bring euro short rates back in line with US dollar rates. Figure 2 illustrates the situation: when excess liquidity in the European banking system fell last November, interbank rates increased and pushed euro rates up from about 10bps last October to near 20bps by year end. The resulting positive spread with US dollar short rates supported a strong euro. The latest changes effectively remove this differential with US rates.
Targeted long-term refinancing operations (TLTROs)
Small and medium-sized enterprises (SMEs) in Europe are still highly dependent on bank lending. Figure 3 demonstrates that there is marginal credit growth in countries like Germany and France, but considerably shrinking credit in peripheral Europe and the eurozone as a whole. As a result, in the region, capital is scarce for those businesses that need it the most, i.e. SMEs in Italy and Spain. Figure 4 shows the elevated interest rates that companies have to pay for loans in these countries. Recognising that credit growth increases inflation, the ECB has come to the rescue and, for the first time in its history, is providing three- to four-year loans to banks aimed at expanding credit to non-financial private businesses (via collateral rules).
The banks have, by now, paid back most of the ECB’s unconditional 2011 LTROs. So, given that they are not using the unconditional LTROs, why should they now embrace conditional LTROs? The answer is simple: the new TLTROs are more attractive. The interest rate of the unconditional LTROs tracked changes in the MRO policy rate over the life of the loan. In contrast to this, the cost of the new TLTROs is fixed for the life of the loan at the prevailing MRO rate at the time of take-up, plus a 10bps spread. Since the MRO rate will almost certainly not rise during 2014, banks can now lock in up to four-years’ funding for just 25bps. As a result it can be expected that banks max-out the initial allowance at the September and December auctions, resulting in a cumulative draw of about €400bn. It is possible for the programme to expand if banks respond as intended – by boosting loans made to businesses.
The AQR completion may be a turning point for credit growth
One caveat to note is that European banks are still concerned over capital adequacy requirements and may be less inclined to increase lending (especially to non-domestic entities) until the completion of the ECB’s asset-quality review (AQR) in November. The AQR will involve the ECB telling some banks to improve their capital buffers, with those unable to raise new capital likely to resort to further balance-sheet deleveraging. Therefore, the announcement of the AQR results – which includes the specifics for future stress testing – may be a vital turning point for the economy. Banks will have a clearer notion of whether they can expand their balance sheets and make use of the easy monetary conditions.
So will the new TLTROs be a success? A look at the UK’s Funding for Lending Scheme (FLS) – which bears many similarities to the ECB’s TLTRO programme – is not very encouraging. Interest rates on loans in the UK fell significantly after the FLS was introduced. Nevertheless, the volume of new lending to businesses failed to pick up. Given that credit growth tends to lag economic activity, there is however reason for optimism. Now that fiscal policies have started to tilt towards growth, the lacklustre banking activity might take care of itself (Figure 5).
Peripheral bonds close to fair value, but equities still look strong
In the nearly two years since Mr Draghi’s ‘whatever it takes’ speech, peripheral eurozone bond yields have fallen dramatically. Spanish 10-year government bond yields fell by over 4% and now trade at a similar level to US government bonds. In the wake of government yields, corporate bond yields also fell to record lows and the divergences between core/peripheral and financials/non-financials shrank considerably (Figure 6).
European banks, reluctant to increase lending in the near term, may use the ECB’s excess liquidity provision to purchase domestic sovereign assets. The resulting decline in yields could reduce the attractiveness of holding periphery sovereign debt, given their proximity to fair value, and in the coming months we may see some profit taking when bond prices rise.
We believe that European equities may benefit from the ECB’s latest stimulus package. Business confidence is likely to gain momentum on the back of policy initiatives to stimulate lending, which may generate greater economic activity and help earnings growth return to a positive territory in 2014 (Figure 8). While European stocks are not as cheap as they were last year, any acceleration in earnings may keep valuations relatively inexpensive compared to other G10 stock markets. As such, we retain a positive outlook for European equities and see greater potential for returns compared to bonds, where gains are likely to be capped.
Will policy help guide the euro lower?
Weak inflation has been driven by a combination of internal and external factors. While the liquidity-based measures are unlikely to have any immediate impact on the real-economy in light of an impaired bank-lending channel, the ECB may hope that the introduction of policy will act as a signal of intent and help curb the strength of the euro (as its negative impact on imported inflation had been a particular cause of concern for ECB board members). To some extent this may have been vindicated: the euro trade-weighted index dropped 1.1% in the week following the policy announcement in June.
Market analysts, including ourselves, have been frustrated by the euro’s year-to-date strength, as the expected divergence of monetary policy in Europe and the US led many to take a bearish stance on euro-dollar. Following the ECB’s decision to actively stave-off persistent low inflation, we now believe that (a) the factors that previously drove the euro higher are fading and (b) monetary policy dynamics will finally see the euro move lower.
Part of the euro strength observed earlier this year can be explained by European banks deleveraging and their unwillingness to convert net portfolio investment inflows into foreign lending. Investors, anticipating that bank hoarding would keep the euro supported, felt less inclined to hedge their euro-denominated positions in a low-volatility environment. This created a mismatch on the balance of payments, with the euro subsequently rising to balance transactions. However, the ECB’s negative deposit rate effectively reduces hedging costs for foreign holders of euro-denominated assets; this could encourage investors to start hedging their exposures with the subsequent short positions weighing on the euro. Furthermore, equity flows are unlikely to offset the reduced attractiveness of periphery bonds and we could see investors turn from net buyers to net sellers of European assets. Figure 9 shows that this reversal may already be in flight, as evidenced by April’s trade data.
In this era of unprecedented low interest rates, it is the real (and not the nominal) interest-rate differential that has been a key driver of G10 currencies. Since 2012, the declining euro area inflation outlook led to a divergence of real interest rates relative to the US and UK, where aggressive policy created inflationary pressures (Figure 10). Should the ECB’s stimulus be deemed credible then markets are likely to raise expectations of inflation, pushing real interest rates lower and initiating a sustained trend of euro depreciation.
So what next for the ECB?
The ECB’s delivery of a comprehensive easing package sent a strong signal to markets and showed a clear commitment – in line with the “whatever it takes” philosophy – to tackle persistently low inflation. The aim now will be to maintain credibility over the coming months; the overall success of the stimulus will be gauged by the central bank’s ability to lower the future interest rate path and anchor medium-term inflation expectations.
Figure 12 shows that the initial response to the policy has been positive and, barring any significant deterioration of actual or expected inflation, we do not see the ECB implementing a “QE” asset purchase programme in the near term. Instead, the likely focus will be on the execution of targeted lending, specification of the SME lending scheme and completion of the AQR (the latter may prove a turning point for lending conditions). Any reversal in core inflation, based on the ECB’s own projections, is likely to be protracted due to the time lag for policy to feed through to the real economy. As such a “wait-and-see” approach may, in reality, be “wait-and-hope”. The ECB has made its move, but it is the market’s confidence over future inflation and growth that will ultimately guide the euro area to recovery.