9/9/18: The end of the clam before the storm

My article on the shifting landscape for monetary policies: U.S. and Euro area for Sunday Business Post https://www.businesspost.ie/business/end-calm-storm-424321

21/7/17: Professor Mario: Meet Irish Austerity Unsung Hero

In the previous post covering CSO's latest figures on Irish Fiscal metrics, I argued that the years of austerity amount to little more than a wholesale leveraging of the economy through higher taxes. Now, a quick note of thanks: thanks to Professor Mario Draghi for his efforts to reduce Government deficits, thus lifting much of the burden of real reforms off Irish political elites shoulders.

Let me explain. According to the CSO data, interest on Irish State debt obligations (excluding finacial services rescue-related measures) amounted to EUR 5.768 billion in 2011, rising to EUR7.298 billion in 2012 and peaking at EUR 7.774 billion in 2013. This moderated to EUR 7.608 billion in 2014, just as Professor Mario started his early-stage LTROs and TLTROs QE-shenanigans. And then it fell - as QE and QE2 programmes really came into full bloom: EUR6.854 billion in 2015 and EUR6.202 billion in 2016. Cumulative savings on interest since interest payments peak amounted to EUR2.65 billion.

That number equals to 75% of all cumulative savings achieved on the expenditure side (excluding capital transfers) over the entire period 2011-2016. That's right: 3/4 of Irish 'austerity' on the spending side was accounted for by... reduction in debt interest costs.

Say, thanks, Professor Mario. Hope you come visit us soon, again, with all your wonderful gifts...

28/2/16: ECB in March: A Thaw or a Spring Blizzard?

My comment on what to expect from the ECB in March for Expresso http://en.calameo.com/books/004629676f86bc6c6796a.

As usual, full comment in English here:

While the transmission mechanism has been improving in recent months across the euro area, leading to stronger lending conditions across the common currency area and a wider range of the member states' economies, inflationary dynamics remained extremely weak, even when stripping out the effects of oil and other commodities prices. As the result, ECB continues to see inflation as the key target and is likely to intensify its efforts to boost price formation mechanism.

Thus, despite all the ECB efforts, inflation remains stubbornly low and even slipping back toward zero in more recent data prints. Improved lending is not sufficient to create a major capex boost on the ground, weighing heavily on growth dynamics. Lower costs of borrowing for the euro area governments, while providing significant room for fiscal manoeuvre, is simply not sufficient to sustain a robust recovery. About the only functioning side of the monetary policy to-date has been the devaluation of the euro vis a vis the US dollar - a dynamic more influenced by the Fed policy stance than by the ECB alone.

My expectation is that the ECB will cut its deposit rate to -40 bps (a cut of 10 basis points on current) with a strong chance that such a cut can be even deeper. We can further expect some announcement on an extension of the QE programme beyond the end of 1H 2017.

The key problem, however, is that the ECB is also becoming more and more aware of the evidence that past QE measures in Japan, the UK, the euro area and across Europe ex-Euro area have failed to deliver a sufficient demand side boost to these economies. Thus, in recent months, the ECB has been increasing rhetorical pressure on member states governments to engage in supply side stimuli. Unfortunately, this too is a misguided effort.

In the present conditions, characterised by markets uncertainty, heavy debt overhangs and mis-allocated investment on foot of previous QE rounds, neither supply nor demand sides of the policy equation hold a promise of repairing the euro area economy. In addition, accelerated QE will likely feed through to the markets via higher volatility and possible liquidity tightening (bid-ask spreads widening, fear of scarcity of high quality government bonds and uncertainty over viability of the current monetary policy course).

29/12/15: There Are Two Ways 2016 Can Play Out for Euro Area Bonds

With the pause in ECB QE over the holidays season, bond markets have been largely looking forward to 2016 and counting the blessings of the year past. The blessings are pretty impressive: ECB’s purchases of government bonds have driven prices up and yields down so much so that at the end of this month, yields on some USD1.68 trillion worth of Government bonds across 10 euro area countries have been pushed below zero.

Per Bloomberg chart:

Value of bonds with yields below ECB’s -0.3% deposit rate, which makes them ineligible for purchases by the ECB, is $616 billion, just shy of 10 percent of the $6.35 trillion of bonds covered by the Bloomberg Eurozone Sovereign Bond Index. As the share of the total pool of marketable European bonds, negative yield bonds amounted to more than 40% of the total across Europe at the start of December (see here: http://www.marketwatch.com/story/40-of-european-government-bonds-sport-negative-yields-and-more-may-follow-2015-12-02).

Two questions weigh on the bond markets right now:
1) Will the ECB expand the current programme? Market consensus is that it will and that the programme will run well beyond 1Q 2016 and spread to a broader range of securities; and
2) Will low inflation environment remain supportive of monetary easing? Market consensus is that it will and that inflation is unlikely to rise much above 1% in 2016.

In my view, both consensus positions are highly risky. On ECB expectations. Setting aside inflationary dynamics, ECB has continuously failed to ‘surprise’ the markets on the dovish side. Nonetheless, the markets continued to price in such a surprise throughout 2015. In other words, current pricing is probably already reflecting high probability of the QE extension/amplification. There is not much room between priced-in expectations and what ECB might/can do forward.

Beyond that, my sense is that ECB is growing weary of the QE. The hope - at the end of 2014 - was that QE will give sovereigns a chance to reform their finances and that the economies will boom on foot of cheaper funding costs. Neither has happened and, if anything, public finances are remaining weak across the Euro area. The ECB has been getting a signal: QE ≠ support for reforms. And this is bound to weigh heavily on Frankfurt.

On inflationary side, when we strip out energy prices, inflation was running at around 1.0% in November and 1.2% in October. On Services side, inflation is at 1.2% and on Food, alcohol & tobacco it is at 1.5%. This is hardly consistent with expectations for further aggressive QE deployment and were ECB to engage in more stimulus, any reversion of energy prices toward the mean will trigger much sharper tightening cycle on monetary side.

The dangers of such tightening are material. Per Bloomberg estimate, a 1% rise in the U.S. Fed rates spells estimated USD3 trillion wipe-out from the about USD45 trillion valuation in investment-grade bonds issued in major currencies, including government, corporate, mortgage and other asset-backed securities tracked by BAML index:

Source here.

European bonds are more sensitive to the ECB rate hikes than the global bonds are to the Fed hike, primarily because they are already trading at much lower yields.

Overall, thus, there is a serious risk build up in the Euro area bond markets. And this risk can go only two ways in 2016: up (and toward a much worse blowout in the future) or down (and into a serious pain in 2016). There, really, is no third way…

28/8/15: Inflation Expectations: Euro and U.S.

Having earlier posted a chart on Central Banks balancesheets expansion (see here), here is an interesting chart plotting inflation expectations (5yr5yr swaps - effectively markets expectations for 5 years from now inflation average over subsequent 5 years)

The above shows that although there has been an uplift in Euro area inflation expectations over the course of 2015 to-date, consistent with QE carried out by the ECB, the expectations have tanked since the start of Q3 2015 in line with those in the U.S.

More ominously, expectations remain in the territory where neither the Fed nor the ECB are capable of convincingly exiting monetary easing.

While the U.S. expectations are closer to target (at 2.23%) but still weak, Euro area expectations are exceptionally weak at 1.63%. Gotta do some more printing (for ECB) and less talking about tapering (for both the Fed and the ECB)...

14/1/2015: ECJ Advocate on OMT: We Allow Fudge

Big news today is old news of yesterday:

We can now expect the European Court of Justice to give green light to the ECB's Outright Monetary Transactions (OMT) program as being 'compatible with EU law'. This is based on the interim ruling made today by the ECJ's Advocate General Pedro Cruz Villalon. In the tradition befitting European institution, Villalon said OMT is legal "in principle" under the EU treaty as long as it meets certain criteria.

The restriction is that the ECB refrains from "direct involvement" in fiscal/government financing (which can be satisfied by ECB buying sovereign debt via secondary markets alone). The problem here is that currently secondary markets are already pricing in huge premium on sovereign bonds, with many (including some 'peripheral' countries') bonds trading at negative rates. So ECB will be de facto buying an overpriced paper. The key question, therefore, is who carries two risks:
1) Market risk relating to market pricing (if bonds prices slip over time); and
2) Default risk relating to sovereign decisions (if bonds carry haircuts in the future).

More on these risks later today.

Key point missed by many commentators is that approving OMT does not equate to approving QE. Another key point is that ECB QE is restricted not only by the objections to any purchases of sovereign bonds, but also by the objections to the potential modalities of purchases, such as total quantum, the distribution of purchases across the member states and the nature of risk sharing. The latter problems were not addressed by the ECJ.

All in, there is little new in the ECJ ruling. ECJ traditionally rubber-stamps EU-centric measures. Hence, given the EU support for QE, the decision is hardly a watershed.


Background to ECJ decision:

The key issue to be decided by the ECJ is whether the ECB has, in principle, a right to purchase sovereign bonds outside the immediate monetary policy considerations (e.g. supply of liquidity to the banking sector).

Back in July 2014, Germany’s Constitutional Court criticised the OMT, saying it probably overstepped the boundaries of monetary policy allowed to ECB. However, the German Constitutional Court ruling effectively gave ECJ full consideration of the OMT legality. OMT traces back to July 2012, when ECB President, Mario Draghi, vowed to do “whatever it takes” within the ECB's mandate to save the euro.

The ECJ heard arguments from both sides of the OMT divide in October 2014.


What to expect next:

Technically, German court can revisit the issue after the ECJ ruling, but most likely, a favourable ruling from the ECJ will allow ECB to push forward with some direct QE measures, such as buying government bonds in the markets. The key question, therefore, is whether the quantity of purchases will be sufficient to stimulate the euro area economy or will it fall short of the required. Rumours have it, the ECB is likely to buy up to EUR500 billion worth of sovereign bonds on top of EUR1 trillion programmes to purchase private assets. One sure bet is that the move will be a huge support scheme for bondholders and banks, who will witness significant appreciation in the value of their bond holdings. ECB purchases will do nothing to ease the burden of already excessive government debt levels. And, depending on modalities, the ECB purchases of bonds can have little impact on aggregate demand in the euro area economy.

We can, nonetheless, expect some sort of a bold QE-related announcement at the next ECB meeting.

Key point is that even if ECJ approves OMT legality, we will need to see the details of the QE programme to make any judgement as to its potential effectiveness. The fudge of ECB policy 'innovations' lives on.

18/9/2014: Quite a disappointing TLTRO round 1

So ECB's first tranche of TLTROs allotted at EUR82.6 billion - which is disappointing to say the least. Announcement is here: http://www.ecb.europa.eu/press/pr/date/2014/html/pr140918_1.en.html

Prior to the allotment, the following were forecast:

• Credit Agricole: EUR100 billion (EUR200 billion into December tranche)
• Goldman Sachs: EUR200-260 billion in September and December TLTROs and EUR720-910 billion in overall programme
• Morgan Stanley: EUR250 billion in September & December TLTRO tranches and EUR100-400 billion for tranches 3-8
• Nomura EUR115 billion in September and EUR165 billion in December
• JPMorgan EUR150 billion in September
• Barclays EUR114 billion in September and EUR154 billion in December.

My own view on the subject as follows (from a comment given yesterday for international publication).

Note that the take up today has been disappointing for all above expectations (my own included), suggesting that traditional LTROs roll-overs dominated decision on TLTRO demand. This means that going into AQR reviews by the ECB the banks are reluctant to expand their corporate lending balance sheets and the loading now is on much heavier take up of TLTROs in December. In the mean time, low take up in this tranche can put some added pressure on ECB to deploy its ABS purchasing programme.


TLTROs vs LTROs

The key difference between TLTROs and LTROs is in the targeted nature of TLTROs. Conventional LTROs (despite the fact that term 'conventional' can hardly apply to these rather exceptional instruments) are unrelated to the balancesheet exposures of the banks and are designed to simply inject medium-term and long-term liquidity into the banking system as a whole. Thus, in the environment of deleveraging and uncertainty with respect to future losses, LTRO-raised funds flow to government securities with lower / zero risk-weighting and high liquidity. The effect is to reduce yields on Government securities, without providing any meaningful uplift in lending to the real economy. De facto, LTROs helped alleviate the sovereign debt crisis on 2010-2011, but also resulted in increased credit markets fragmentation and did nothing to reduce credit supply pressures in the real economies of the euro area countries. TLTROs - via targeting levels of real credit exposures to non-financial corporations - are holding a promise to shift funds into credit markets for companies, with weighting formula favouring banks with greater exposures to such lending. If successful, TLTRO programmes can incentivise banks to lend on the basis of risk-return valuations, which can, in theory, also alleviate the problem of financial markets fragmentation by attracting euro area banks into lending in the so-called 'peripheral' economies.

At this stage, both demand and supply of credit in the majority of the euro area economies are well outside the fundamentals-determined levels. The financial markets are severely fragmented and the ongoing deleveraging of the banks and companies balancesheets still working through the credit markets. This means that any forecast for TLTROs uptake and effectiveness are subject to huge uncertainty. My view is that we are likely to see rather cautious take up of the TLTRO funds in the first round, with many lenders dipping into the funding stream without full commitment. We are looking at the take up of around EUR100-150 billion in Thursday TLTROs. One reason for this is that the first tranche of TLTROs is likely to go into replacing maturing 3-year LTRO funds rather than new expansion of the banks balancesheets. To-date, banks repaid some EUR649 billion of LTROs, with EUR370 billion outstanding. Close-to-redemption LTRO funds need replacement and TLTROs are offering such an opportunity, albeit at a cost (TLTROs are priced 10bp higher than LTROs but offer longer maturity). All-in, the banks are likely to go for roughly EUR300 billion of TLTROs (with total potential allotment of EUR400 billion available, the cost will be the main factor here), with under half of this coming in September and the balance in December. Another reason pushing TLTROs demand into December, rather than September, is the ongoing ECB review of the banks (AQR analysis).

TLTROs, ABS and QE

ABS measures are going to aim to address the size of the ECB balancesheet, while providing support for effective yield on loans to the real economy. In this, well-structured ABS purchasing programme can provide support for TLTROs by increasing incentives for the banks to lend funds to corporates. However, excessive focus in the ABS programme on quality of assets and risk pricing can posit a risk of increasing fragmentation in the markets, as such focus can drive a significant wedge in pricing between corporate yields in the core economies of the euro area and the 'periphery'.

I do not see the ECB deploying traditional QE programme at this point in time. The reason for this is simple: yields convergence in the Sovereign markets is ongoing, levels of yields are benign, and demand for sovereign assets remains strong. However, if TLTROs and ABS programmes prove to be successful, we may see banks exits from low-yielding sovereign debt (core euro area) and from high yield, but now significantly repriced peripheral debt (profit taking). Unlikely as this might be at this point in time, if such exits prove to be aggressive, the ECB will have to provide support for sovereign yields and a small-scale QE can be contemplated in this case.

In general, however, it is clear from Mr Draghi's recent speeches and statements that he sees two key problems plaguing the euro area economies: the problem of high structural and cyclical unemployment and the problem of low private investment. Both of these problems continue to persist even as the sovereign debt yields have fallen dramatically, suggesting that government spending stimulus and investment programmes are unlikely to repair what is structurally a longer-term set of weaknesses in the economy.

30/5/2013: A reminder of the road to be travelled

The Chart of the Week from the zerohedge:

There is little new in the chart and it has been reproduced many times before, yet it still strikes the 'Wow!' cord for me. Now, back in 2010 (here) I argued that the Euro area will have to print ca EUR 3 trillion to get itself out of the pickle jar. The US - with a much lighter problem load than the Euro area - USD 2.3 trillion on the printing side alone, ex other measures, already, and climbing.