Assessing The Aftermath Of ECB Policy Action

BMI View: The European Central Bank (ECB) has delivered on nearly all of the policy options that we were expecting for the June 5 meeting. This is a step in the right direction for warding off the risk of deflation and will be positive for European equities and sovereign bonds. However, we warn - as we have done countless times during previous easing rounds - that the efficacy of ECB policy action will be limited absent structural reforms in the eurozone at the national and federal level.

Having upped the rhetoric in the run up to the June 5 monetary policy meeting, there was a risk that the European Central Bank (ECB)'s efforts to manage expectations could backfire in the event of the policy outcome falling short of the mark. However, by and large the ECB enacted the policy measures that we had expected (see Crunch Time For The ECB: A Policy Primer, May 2014). We reiterate our initial response to yesterday's meeting:

"The European Central Bank (ECB) introduced an array of measures to ease monetary policy on June 5. These included a 10bps cut to the refinancing rate (to 0.15%) and the deposit rate (to -0.10%), a 35bps cut to the marginal lending rate (to 0.40%), targeted long-term refinancing operations (TLTRO, of EUR400bn), a suspension of SMP (securities market programme) sterilisation, and an extension of short-term fixed-rate full-allotment lending. We previously argued that a 10bps cut to the refinancing and deposit rates, a targeted LTRO of under EUR500bn and a suspension of SMP sterilisation were medium-to-high probability events, and that there was a good chance that this mix of policies would be implemented at the June 5 monetary policy meeting. We also pointed out the possibility of a negative deposit rate being applied to current accounts covering the minimum reserve system (which the ECB has now introduced). The ECB did not unveil an Asset Backed Security (ABS) purchase programme, which we attached a medium-to-high probability to, but has indicated that it is preparing the way to implement such a scheme. Finally, we asserted that a cut to banks' minimum reserve ratio requirement was unlikely and that there was a low probability of a quantitative easing programme being introduced, but a slightly higher probability of a preannounced QE programme (essentially a blueprint for how QE could be implemented if necessary). The ECB did not cut reserve ratios or introduce a QE programme as expected, and also made no preannouncements on QE."

Has Draghi Delivered?
Eurozone - ECB Policy Measures, EURbn

BMI View: The European Central Bank (ECB) has delivered on nearly all of the policy options that we were expecting for the June 5 meeting. This is a step in the right direction for warding off the risk of deflation and will be positive for European equities and sovereign bonds. However, we warn - as we have done countless times during previous easing rounds - that the efficacy of ECB policy action will be limited absent structural reforms in the eurozone at the national and federal level.

Having upped the rhetoric in the run up to the June 5 monetary policy meeting, there was a risk that the European Central Bank (ECB)'s efforts to manage expectations could backfire in the event of the policy outcome falling short of the mark. However, by and large the ECB enacted the policy measures that we had expected (see Crunch Time For The ECB: A Policy Primer, May 2014). We reiterate our initial response to yesterday's meeting:

"The European Central Bank (ECB) introduced an array of measures to ease monetary policy on June 5. These included a 10bps cut to the refinancing rate (to 0.15%) and the deposit rate (to -0.10%), a 35bps cut to the marginal lending rate (to 0.40%), targeted long-term refinancing operations (TLTRO, of EUR400bn), a suspension of SMP (securities market programme) sterilisation, and an extension of short-term fixed-rate full-allotment lending. We previously argued that a 10bps cut to the refinancing and deposit rates, a targeted LTRO of under EUR500bn and a suspension of SMP sterilisation were medium-to-high probability events, and that there was a good chance that this mix of policies would be implemented at the June 5 monetary policy meeting. We also pointed out the possibility of a negative deposit rate being applied to current accounts covering the minimum reserve system (which the ECB has now introduced). The ECB did not unveil an Asset Backed Security (ABS) purchase programme, which we attached a medium-to-high probability to, but has indicated that it is preparing the way to implement such a scheme. Finally, we asserted that a cut to banks' minimum reserve ratio requirement was unlikely and that there was a low probability of a quantitative easing programme being introduced, but a slightly higher probability of a preannounced QE programme (essentially a blueprint for how QE could be implemented if necessary). The ECB did not cut reserve ratios or introduce a QE programme as expected, and also made no preannouncements on QE."

How Do The New Measures Stack Up?

Given that the eurozone economy is struggling to gain momentum and inflation is perilously low, another round of monetary easing is long overdue. We view yesterday's stimulus measures as a step in the right direction for warding off the risk of deflation. However, we are under no illusion that the policy options enacted by the ECB will be the saving grace of the eurozone. The sum total of the measures is smaller in magnitude than the previous EUR1trn LTRO round in 2011/2012, which itself did not trigger a revival in lending to the economy.

Has Draghi Delivered?
Eurozone - ECB Policy Measures, EURbn

The chart above shows the potential monetary value of yesterday's policy measures compared with the EUR1trn LTRO. Suspension of securities market programme (SMP) sterilisation could free up EUR165bn, the targeted LTRO (TLTRO) will be worth EUR400bn, while the combination of deposits and current accounts covering the minimum reserve system (which are now being charged a negative interest rate) total EUR249bn. Altogether this comes to EUR814bn. As such, for the time being the ECB has delivered a smaller package than the previous LTRO. Only if the ECB goes ahead with an ABS purchase programme, which could add another few hundred billion euros to the total, would both unconventional easing rounds be of similar magnitude.

Even then, the impact of policy easing is not clear cut. First, the liquidity released from suspended SMP sterilisation is unlikely to flow straight into the broader economy. Banks may decide to use excess funds to repay LTRO loans. Second, even with a negative deposit rate banks could still decide to bite the bullet and pay to store reserves at the ECB. Similarly, while the negative rate charged on current accounts covering the minimum reserve system may have a greater impact given the higher sum involved (EUR209bn compared with EUR40bn in the deposit facility), banks will still need to meet reserve requirements during the minimum reserve period, so the full amount currently on deposit will not feed 1:1 into private sector credit supply.

Finally, as the chart below shows, the first big LTRO round did nothing to revive lending to households and the corporate sector. The new LTROs may represent a smaller block of liquidity, but the inbuilt conditionality (banks can only borrow funds provided that they lend to the private sector) and longer term (four years, instead of three) are a positive development. However, banks are under no obligation to borrow from the ECB and, as we have warned previously, may decide not to given that their balance sheets are being scrutinised as part of the ongoing Asset Quality Review. Moreover, the Bank of England's experience with the Funding for Lending Scheme (FLS), which the TLTROs mirror, shows that conditional lending can fail to drum up enough demand.

Previous LTRO Failed To Revive Credit Growth
Eurozone - Credit To Households & Non-Financial Corporates, % chg y-o-y

Interest Rates: A Gentle Push Into The Unknown

The landmark policy change has been the introduction of negative deposit rates - a policy which carries the most systemic risk and represents a real gamble for the ECB. We previously highlighted that the apparent agreement among ECB members that a negative deposit rate would decisively weaken the euro, made it likely that this policy would be pursued given the concern that euro strength was driving the eurozone towards deflation. Again, however, we are less optimistic about the positive impact of negative rates, while also believing that the potential systemic risks have been overplayed. The meagre 10bps cuts to the refinancing and deposit rates pales in comparison with the previous easing rounds (see chart below) and at this stage will have little impact on lending to the economy.

Modest Cuts, But Unchartered Territory
Eurozone - Cumulative Interest Rate Cuts, bps

Encore!

Ahead of the ECB meeting we argued that absent the introduction of quantitative easing (which we saw as very unlikely), the best policy outcome would be a mix of interest rate cuts and unconventional monetary easing of the sort that the central bank delivered. We stressed that this would be positive for equities and bonds, with the drop in periphery sovereign bond yields (see the Italian 10-year yield below) and uptick in German stocks bearing this out. Although additional gains could be limited (periphery equities perhaps offer the best upside potential), we believe that the ECBs measures will nonetheless remain supportive.

Clearest Impact Of ECB Policy Seen In The Bond Markets
Italy - Generic 10-Year Government Bond Yield, %

The most interesting move has been in the euro. Ahead of the meeting we stated that the euro could strengthen even if the ECB eased monetary policy, if the market was underwhelmed by the central bank's actions. The euro dived following the initial interest rate decision at 13:45 CET, which likely reflected anticipation of unconventional easing measures being announced at the press conference held at 14:30 CET, rather than being driven by the rate cuts. By the end of the day the euro was stronger than before the meeting, and edged up further against the US dollar on June 6. Although it is still too early to determine with any conviction which way the euro will head in the near term (the market has plenty to digest from yesterday's myriad of policies), the initial market movement is not a good sign for the ECB, which is banking on a weaker euro.

Underwhelmed?
Eurozone - 5-minute Intraday USD/EUR

At this point we stress that there is more to come. The ECB is paving the way for an ABS purchase programme, while Draghi indicated that the central bank is willing to do more: "Are we finished? The answer is no! We aren't finished here. If need be, within our mandate, we aren't finished here." Taken alongside the ECB's weak inflation expectations, we believe that the stage is set for further easing measures, and we are confident in maintaining our multi-year bearish euro position which we set out in April. Even with further stimulus measures, we maintain our longstanding concern: ECB easing will only deliver temporary respite to the eurozone economy in the face of limited structural reforms at the national and federal level. The only way to engineer a sustainable economic recovery and deal a decisive blow to systemic crisis risks (particularly unwieldy sovereign debt trajectories) is to take a leap of faith in the direction of a combined banking, political and fiscal union. The recent European Parliament elections leave us in no doubt that the outlook for structural reform has not materially improved, and has likely worsened.

Read the full article

This article is tagged to:
Related sectors of this article: Economy, Monetary Policy
×

Enter your details to read the full article

By submitting this form you are acknowledging that you have read and understood our Privacy Policy.