9/6/2014: ECB Will Still Need Outright QE...

My comments on ECB policy moves last week and what awaits euro area in terms of monetary policies in the near future is on Expresso website (Portuguese) : http://expresso.sapo.pt/bce-pode-estar-a-alimentar-duas-bolhas-financeiras=f874782 and a longer version in English here: http://janelanaweb.com/novidades/constantin-gurdgiev-ecb-will-need-further-measures-including-an-outright-qe/

Needless to say, no one in the Irish mainstream media asked for my two-pence.

5/6/2014: Why ECB might have found a cure that strengthens the disease

Today's announcement by the ECB Governing Council that the Bank will be charging a premium to hold private banks' deposits has the potential to generate two positive effects and one negative, in the short run, as well as another negative in the medium-term. The ECB cut its deposit rate to minus 0.1 percent from zero and reduced its benchmark interest rate to a record-low 0.15 percent.

On the positive side,

1. Lower repo rate can translate, at least partially, into lower rates charged on variable rate legacy loans and new credit extended to households and companies. It will also reduce the cost of borrowing in the interbank markets. This potential, however, is likely to be ameliorated, as in the past rate reductions, by banks raising margins to increase profitability and improve the rate of loans deleveraging. This time around, the ECB introducing negative deposit rates is designed to reinforce the effect of the lending rate reduction. Negative deposit rate means that banks will find it costly to deposit funds with the ECB, in theory pushing more of these deposits out into the interbank lending market. With further reduction in funding costs, banks, in theory can borrow more from each other and lend more into the economies, including at lower cost to the borrowers. Note: in many countries, like Ireland, reduced lending rates will likely mean a re-allocation of cost from tracker loans (linked to ECB headline rate, their costs will fall) to variable rates borrowers (whose costs will rise) washing the entire effect away.
2. Negative rates, via increasing supply of money into the economy, are hoped to drive up prices (reducing the impact of low inflation) and, simultaneously, lower euro valuations in the currency markets (thus stimulating euro area exports and making more expensive euro area imports. The good bit is obvious. The bad bit is that energy costs, costs of related transport services, other necessities that euro area imports in large volumes will have to rise, reducing domestic demand and increasing production costs.

On the negative side,

1. The ECB has spent all bullets it has in terms of lending rate policy. At 0.15 percent, there is very little room left for ECB to manoeuvre and should current policy innovations fail, the ECB will be left with nothing else in its arsenal than untested, dubiously acceptable to some member states, direct QE measures. 
2. But there is a greater problem lurking in the shadows. US Fed Chair, Janet Yellen clearly stated last year that deposits rates near zero (let alone in the negative territory) can trigger a significant disruption in the money markets. If banks withhold any funds from interbank markets, the new added cost of holding cash will have to be absorbed somewhere. If the banks pass this cost onto customers by lowering dramatically deposit rates to households and companies, there can be re-allocation of deposits away from stronger banks (holding cash reserves) to weaker banks (offering higher deposit rates). This will reduce lending by better banks (less deposits) and will not do much for increasing lending proportionally by weaker banks (who will be paying higher cost of funding via deposits). Profit margins can also fall, leading all banks to raise lending costs for existent and new clients. If, however, the banks are not going to pass the cost of ECB deposits onto customers, then profit margins in the banks will shrink by the amount of deposits costs. The result, once again, can be reduced lending and higher credit costs.

On the longer term side, assuming that the ECB measures are successful in increasing liquidity supply in the interbank markets, the measure will achieve the following: stronger banks (with cash on balance sheets) will now be incentivised (by negative rates) to lend more aggressively (and more cheaply) to weaker banks. This, de facto, implies a risk transfer - from lower quality banks to higher quality banks. The result not only perpetuates Europe's sick banking situation, and extends new supports to lenders who should have failed ages ago, but also loads good banks with bad risks exposures. Not a pleasant proposition.

By announcing simultaneously a reduction in the lending rate and the negative deposit rate, the ECB has entered the unchartered territory where negative effects will be counteracting positive effects and the net outcome of the policies is uncertain.

Aware of this, the ECB did something else today: to assure there is significant enough pipeline of liquidity available to all banks, it announced a new round of LTROs - cheap funding for the banks - to the tune of EUR400 billion. The two new LTROs are with a twist - they are 'targeted' to lending against banks lending to businesses and households, excluding housing loans. TLROs will have maturity of around 4 years (September 2018), cannot be used to purchase Government bonds (a major positive, given that funds from the previous LTROs primarily went to fund Government bonds). Banks will be entitled to borrow, initially, 7% of the total volume of their loans to non-financial corporations (NFCs) and households (excluding house loans) as of April 30, 2014. Two TLTROs, totalling around EUR400 billion will be issued - in September and December 2014. The ECB also increased supply of short term money. TLTROs are based on 4 years maturity. Ordinary repo lending will be extended in March 2015-June 2016 period to all banks who will be able to borrow up to 3 times their net lending to euro area NFCs and non-housing loans to households. These loans are quarterly (short-term). Crucially, to enhance liquidity cushion even further, the ECB declared that loan sales, securitisations and write downs will not be counted as a restriction on lending volumes.

Thus, de facto, the ECB issued two new programmes - both aimed to supply sheep money into the system: TLTROs (cost of funds set at MRO rate, plus fixed spread of 10 bps) and traditional quarterly lending. There was a shower of other smaller bits and pieces of policies unveiled, but they all aimed at exactly the same - provide a backstop to liquidity supply in the interbank funding area, should a combination of lower lending rates, negative deposit rates and TLTROs fail to deliver a boost to credit creation in NFCs sector.

Final big-blow policy tool was to announce suspension of sterilisation of SMP programme - I covered this topic here. The problem is that Mario Draghi claimed that non-sterilisation decision was acceptable, since non-sterilisation of SMP does not imply anything about sterilisation of OMT (his really Big Bazooka from 2012). He went on to say that ECB never promised to sterilise OMT in the first place. Alas, ECB did promise exactly that here. Update: WSJ blog confirming exactly this and published well after this note came out is here.

In line with this simple realisation - that non-sterilisation of SMP opens the door to outright funding of sovereigns by the ECB via avoidance of sterilising OMT - German hawks were already out circling Mr Draghi's field.

Germany's Ifo President Hans-Werner Sinn said: "This is a desperate attempt to use even cheaper credit and punitive interest rates on deposits to divert capital flows to southern Europe and stimulate their economies," Sinn said on Thursday in Munich. "It cannot succeed because the economies of southern Europe must first improve their competitiveness through labour market reforms. Long-term investors, in other words savers and life insurance policy holders, will now foot the bill," warned Sinn.

And there we go… lots of new measures, even more expectations from the markets and in the end, Germans are not happy, while Souther Europe is hardly any better off… In the long run - weaker banking sector nearly guaranteed… A cure that makes the disease worse?.. And if one considers that we just increased even further future costs of unwinding ECB's crisis policies, may be the disease has been made incurable altogether?..

Here are a couple of charts showing just how massive this legacy policies problem is (although we will face it in the mid-term future, not tomorrow):

Did Draghi just make the impossible monetary dilemma (here and here) more impossible?

11/5/2014: Super Mario: Whatever It Takes Will Now Happen in June… Likely, Like…

This week, the ECB has sent a barrage of signals. Blanket-bombing the Forex markets, Super Mario laid it thick with the promises. Behind this there is less of the classical monetary policy and more of the classical exchange rates expectations balancing. Inflation is low, for sure. Euro is stubbornly stuck in the highs, for sure. The former is just fine for retirement-bound Germany. The latter is not fine for growth centres-bound BMWs and Mercs. So the majority of the Governing Council decided to move… but only in the future… and only once new forecasts are made available.

Basically, Draghi pre-committed to acting in June to ease policy. This is not the same as a promise of QE, neither in the form of actual printing or unconventional measures of any serious significance. Instead, my expectation is the ECB will pass through another refinancing rate cut or do some re-arranging on liquidity support measures side (maturity or volume or both). The Governing Council can then sit back and watch if the marginal move induces downward pressure on the euro. This being June, real economy in Europe will be heading into Summer, buying ECB some time for navel gazing.

Most likely outcome: as long as ECB does not drastically depart from the Fed and BofE, things will remain hard for the euro.

The ECB stance overlays the fundamentals that are consistent with medium-term low inflation and anaemic, albeit improving, growth (see http://trueeconomics.blogspot.ie/2014/05/752014-eurocoin-leading-indicator-april.html). Any easing the monetary policy from here on is therefore consistent with ECB responding to deflationary pressures and Forex pressures, and not to the issues relating to fragmented lending markets. Thus, any easing in June remains conditional on ECB forecasts. Draghi noted as much, stating that

• Going forward, the ECB is still mindful of low inflation and is concerned with the medium-term trajectory in inflation, so that both levels and dynamics seem to matter now (it was the former and not the latter that were of concern before)
• The ECB is also worrying about the high valuation of the euro, especially consistent with low inflation. The two factors reinforce each other in the longer run.
• The fact that geopolitical crisis in Ukraine is now spilling over into the euro area more than to any other region.

The ECB still appears to be undecided on specific tools that it is going to use. Much of this indecision is probably down to the difficulties with structuring some less conventional measures. Much is due to the uncertainty as to how much easing will be required. Intervention for Forex sake will have to be initially smaller than intervention aimed at unlocking fragmented lending markets. This is my expectation for any June action, if any were to take place: symbolic act to alter forward expectations and buy time before end of summer.

The tool kit for this includes potential

• Shallow cut to refinancing rate: -10 to -15 bps
• Extending to full allotment of fixed rate liquidity provision. As Bloomberg puts it: "The ECB could extend its policy of granting as much cash as banks need against eligible collateral. The measure was introduced in October 2008 after the collapse of Lehman Brothers Holdings Inc. sparked a global credit crunch and is scheduled to run until at least July 2015."
• New LTRO. Again, via Bloomberg: "The ECB’s emergency 3-year loans to banks are losing their effectiveness as they approach maturity at the start of 2015, prompting speculation that a new round may be offered. Another LTRO might look different from the previous ones, when banks used most of the liquidity to buy government bonds. “We will want to make sure that this is being used for the economy,” Draghi said in December."
• Non-sterilisation of SMP (I wrote about this earlier here: http://trueeconomics.blogspot.ie/2014/03/07032014-to-sterilise-or-not-to.html). This can ad up to EUR168 billion to liquidity supply.
• Reserve requirements can be lower or ECB can remove the reserve ratio of 1%. Both measures will increase liquidity supply.
• Negative Deposit rate from current zero rate to -0.05 to -0.1 percent (negative rates were used recently in Denmark: http://www.bloomberg.com/news/2014-04-24/danish-central-bank-exits-negative-rates-first-time-since-2012.html). 

I suspect ECB will not go for negative rates, or opt for the outright non-sterilsation of SMP, albeit it can slow down the rate of sterilisation. Negative rates is a nuclear option that will have more significant impact on reducing euro strength. And it might add credit supply in the euro area on the aggregate, though I doubt this will have much of an effect on breaking the vicious cycle of market fragmentation (I find it unlikely that negative rates can trigger restart of credit supply in euro area impaired economies).

In the longer term, I suspect ECB is going to take a wait-and-watch approach through summer. If economic growth continues to pick up and inflation starts to rise, we shall see ECB abandoning any further action beyond the token signalling in June. If things deteriorate over the summer, ECB will look into more QE-focused policies in September-October. Corporate bonds purchases might be on the books then.

Couple of charts to illustrate ECB's long term dilemma:

Policy rates are at historical lows and moving out of synch with Euribor (fragmentation)

Meanwhile, the euribor-ECB spread rose to the highest level since April 2012... The Draghi Put period average spread is at 0.054, pre-Put at 0.594 and current spread is at 0.354. The cost margin in inter-bank markets is now closer to the crisis peak averages than to the Draghi Put average, showing the effects of LTROs and ECB easing wearing out.

And duration and magnitude of deviation from historical averages are frightening:

All of which shows that ECB will have to seriously push the bounds on unconventional measures, if it really wants to make a dent in the pile of problems (forex rates, fragmentation, aggregate liquidity supply, inflation, growth...) the ECB is facing.

07/03/2014: To sterilise or not to sterilise... ECBs (possible) next dilemma

Yesterday, I was asked by a journalist a question about the possible effects of ECB non-sterilising SMP operations. 

The question was in relation to the measure that has been rumoured as being a part of the ECB’s toolkit under consideration for adoption and it is bound to come up in the next meeting of the GC.

The answer is that we do not know.

Currently, ECB is sterilising around EUR175 billion via weekly operations. Absent such sterilisations, the money will remain within the euro system banks. This is as far as we know. Beyond this point, we can only speculate as to what will happen. 

In normal monetary and balancesheet conditions, banks will lend this money out into the interbank markets, leading to reduced Eonia and, downstream also Euribor, rates. This, in turn, will increase banks willingness to lend to the real economy - businesses and households, but also to purchase government debt. Traditionally, non-sterilised market interventions are seen as an effective tool for increasing money supply in the environment of zero-bound interest rates. And there are good reasons to believe that such a measure would be more effective in raising supply of credit in the euro system than a 25bps cut in the policy rate, as it will likely have a more dramatic effect on Eonia rate and simultaneously flatten the money market curve. Additional benefit of such a measure will be the signal it will send to the markets. Removing requirement to sterilise its SMP, ECB will be signalling that it is open to the traditional QE measures - extending 'whatever it takes' argument from sovereign risk markets (OMT) to the real economy (deflation risks). This too is likely to add liquidity available in the euro system.

However, we are not in a 'normal' monetary and balancesheet environment. Increasing supply of liquidity via non-sterilising SMP can lead to banks substituting away from their normal ECB funding, and as the result, net liquidity supply may not rise by as much as the reduction in sterilisations. 

Two other, longer-term, effects of non-sterilising SMP are: potential loss of credibility and threat to OMT.

By not sterilising SMP, the ECB will signal a major departure from its past commitments, which does not help market confidence in its other commitments, namely the commitment to hold interest rates low over long term horizon. This is a relatively weak argument against non-sterilising of SMP, as all long term monetary policy commitments are only credible as long as underlying fundamentals warrant them. The second point is more salient. ECB committed itself to sterilising not only SMP but also OMT purchases. So far, ECB did not make any OMT purchases, but it already faces stern opposition to OMT from Germany. If ECB signals willingness to break its commitments to sterilisation under SMP, it can send a wrong signal on its commitments to the same under OMT, further putting pressure on ECB to scrap OMT.

Overall, materially, removing requirement to sterilise SMP will, in my view, result in a moderate drop in Eonia and will provide improved supply of credit to the economies that currently do not witness severe credit constraints, such as Germany, where current credit supply conditions are already the most favourable of any period in recent history.

But I doubt that such a measure will have a material impact on peripheral economies due to the general breakdown in the transmission mechanism within the euro area.

Crucially, if ECB opts for non-sterilisation of SMP over the option of lowering policy rates, such a move will not help existent debtors. As the result, non-sterilisation might help where help is least needed and will do little to provide any support for economies with severe corporate and household debt overhang.

Finally, along the longer range expectations, forward-looking agents will be pricing – in the wake of non-sterilisation now – higher uplift in lending rates when monetary policy returns onto normalisation path. In other words, with non-sterilisation today we can expect higher rates in the future, with sharper rises in the rates to long-term trend levels. This too will hurt current borrowers, as lender will be less likely to pass on margins uplifts they will receive if non-sterilisation does deliver reduction in the interbank lending rates.

Note: my view of the lower/reduced effectiveness of non-sterilised interventions is in line with the view held by many researchers and the ECB that we are operating in the environment with broken transmission mechanism. Application of this argument in the OMT case is exemplified here: http://www.cesifo-group.de/DocDL/cesifo1_wp4628.pdf

27/7/2012: Some thoughts on Draghi's thoughts

Just two reactions - reflective of the markets sentiment - to yesterday's statements by Mario Draghi:

Markets are thin, as Europe slides into its annual 'Beach lounge & sun screen' mode, but nonetheless yesterday's statement by the ECB chief is significant. Not a game changer overall, yet, but a sign that the team captain is starting to see the problem more clearly.

So what did he really say?

1. Raised a possibility of direct bonds purchases for distressed sovereigns (read: Italy and Spain) - in my opinion a minor issue. Take Spain - from now through mid-2015 it will need €542 billion to roll over existent bonds and fund itself, plus €20 billion potentially in regional financing. ECB's hands are currently relatively tied when it comes to rescuing Spain by the fact that two out of three tools ECB can use to do so are ineffective if not damaging to Spain. Usual policy tool of lowering interest rates will have little-to-no impact on Spain which is suffering from the same breakdown in the monetary policy transmission mechanism as the rest of the euro zone. Draghi hinted at as much within the overall euro area context. ECB can use the LTRO3 tool. Alas, (1) this would mean that LTRO3 will be explicitly focused on financing sovereign (as opposed to banking sector) needs; (2) financing Spanish Government via LTRO3 would only increase contagion from the sovereign to the banks and back to the sovereigns; (3) Unable to issue LTRO to a specific country, the ECB is likely to risk even more carry trade and contagion across the euro zone as the result of such a move. So the only tool left is SMP. ECB has built up some back pressure here with no SMP purchases in 19 weeks, hence the trigger reaction yesterday to Draghi's statement, but I have severe doubts this will work, even if restarted as the scope for SMP purchases for Spain would be well under €75-80 billion - a drop in the funding requirement.
2. Noted that elevated sovereign yields can restrict the monetary policy transmission mechanism (presumably via the heightened liquidity trap effects and carry-trade incentives), which would bring them within the ECB mandate. This is consistent with his statement to the EU Parliament earlier this month where he stressed that both inflation and deflation are part of the ECB mandate. More specifically, Draghi said that "The short-term challenges in our view relate mostly to the financial fragmentation that has taken place in the euro area... Investors retreated within their national boundaries. The interbank market is not functioning... the key strategy point here is that if we want to get out of this crisis, we have to repair this financial fragmentation... So [first] regulation has to be recalibrated completely." In other words, Draghi sees regulatory, not balancesheet barriers to interbank lending (and thus regulatory causes of a liquidity trap). Fine, but that does not mean a short-term response on the cards. And it does not mean a major departure from the previous position of the ECB that regulatory fix must be applied ahead of monetary fix.
3. Spoke about the fact that the ECB mandate is too restrictive to deliver effective monetary policy - again re-iteration on his statement to the EU Parliament and potentially a clear signal the ECB would not mind if its mandate was expanded. Yesterday, Draghi went further to link the ECB unbalanced mandate to the ECB's ability / willingness to act in the sovereign bond markets. This is what referenced in the quote that the ECB is 'ready to do whatever it takes' to preserve the euro. But the quote contains much more than that: "...another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia [relate to] default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty – they come into our mandate. They come within our remit." FTAlphaville has a good note on the convirtibility bit (here).

In short, I don't read Draghi's statement as a major and definitive turnaround in the ECB policy, but rather a continued sign of ECB drift toward pressuring both: 

• the markets sentiment, and 
• the euro area policymakers to act to increase ECB powers and/or carry out significant policy framework changes (ESM, banking union etc).

Continued is the key word here, because, in my view, yesterday's statement is not as divorced from the earlier Draghi comments as some analysts might suggest (or wish for).

These pressures, however, is an important component of policy drift across the euro zone. Leaderless Europe needs a jolt from the ECB to force it out of policy stalemate. That such an approach might be working is reflected in this latest report from the 'front'.