ECB delivers more than expected

ECB cuts its three official rates by 10 bps. Repo now at 0.05%, depo-rate at -0.20%

ABS & new covered bond programmes to be implemented in October

Comfortable majority for decisions, but no unanimity

Nevertheless, ABS programme takes us closer to broad-based QE

“Sources: ECB Weidmann opposed both the rate cut and the ABS program

Concluding, the ECB delivered more than expected

Euro sharply lower, equities higher, while the curve steepens substantially

Following Mr. Draghi’s speech at the Jackson Hole symposium two weeks ago, market were warmed up for the idea that the ECB was ready to ease its policy further. Only three months earlier, the ECB had taken a series of measures which, according to policymakers, would clear the horizon for the rest of the year.

Credit easing the objective for ECB decisions

The ECB didn’t disappoint markets though and went again further than most analysts had expected. It announced another batch of decisions including both unexpected rate cuts and two new asset purchase programmes, one focussed on ABS paper, the other on covered bonds. Mario Draghi emphasized that these decisions are aimed at credit easing. The rate decisions will facilitate participation at the TLTROs, which will be implemented later this month, and weaken the euro.
The asset purchases programmes aren’t yet the broadbased US‐style QE programs some were dreaming of but they certainly bring the ECB closer to such a program. In the eyes of markets today’s decisions were another big step in that direction. Keeping that option open was probably one of Mr. Draghi’s objectives. Admittedly, the decisions were not taken with unanimity, but had according to Mario Draghi a comfortable majority. According to sources, but not wholly unexpectedly, it was Mr. Weidmann who opposed both the rate cut and the ABS programme, the latter likely because he doesn’t want the ECB to take on credit risk. Such a broad‐based QE programme is still controversial and largely opposed by German monetary and fiscal policymakers. The dissenting vote suggests that Mr. Draghi has still a lot of work to do to overcome this resistance in the area’s major country. However, for now, it is impressive how far Mario Draghi has gone in implementing the so‐called unconventional tools.

Downside growth and inflation risks drove the action

Mr. Draghi justified the decisions by the fading growth momentum, the low inflation and the downside risks for a de‐anchoring of inflation expectations. The ECB Governing Council still sees downside risks for the economic outlook and it no longer speaks about balanced risks for the inflation outlook. The ECB now speaks about closely monitoring the risks to the outlook for inflation and focus on the impact of dampened growth dynamics, geopolitical developments, FX developments and the pass through of its policy measures.

The ECB staff growth and inflation projections were only marginally changed compared with the June projections. Economic growth is now expected at 0.9% (1%) in 2014, 1.6% (1.7%) in 2015 and 1.9% (unchanged) in 2016. Inflation is put at 0.6% (0.7%) in 2014, 1.1% and 1.4% in 2015/16 (unchanged versus June).

Lower rates

The ECB unexpectedly cut its three official rates by 10 basis points to respectively 0.05% (repo‐), ‐0.20% (depo‐) and 0.30% (marginal lending rate). By doing so, the ECB not only eased its overall monetary stance, it also aimed specific objectives. Lowering the repo‐rate should help making a success of the TLTROs (4 year funding operation). The TLTRO is priced at repo‐rate plus 10 bps, or 20 basis points for 4‐year funding. This is very attractive for banks and thus participation should be high. TLTROS aim to ease credit constraints. Mario Draghi put a lot of effort in convincing banks to fully take advantage of the TLTRO funding and so his credibility was at stake. The repo‐rate cut should lead to successful TLTROs. The decline of the deposit rate into deeper negative territory surprised us, as we thought that the ECB would be afraid for its consequences on the money market. However, we shouldn’t have been too surprised. In August, Mario Draghi already hailed the success of a negative deposit rate in weakening the euro. So, today’s decision to cut the depo‐rate fits the ECB’s objective to weaken the euro.

Regarding the rate cut, Mr. Draghi assured markets that the lower bound is now effectively reached and thus no further rate cuts should be expected. In June, he said already that rates “for all the practical purposes” are at the lower bound. After today’s rate cut, he added, banks have no reasons anymore not to fully participate in the sharply priced TLTROs. Rates won’t get lower anymore.

New ABS & covered bond programs

In October 2014, the ECB will start buying ABS and covered bonds. Details will be released after the October 2 ECB meeting. Together with the TLTROs, these purchases will have a sizeable effect on the size of the ECB’s balance sheet Mr. Draghi said. He couldn’t give a precise size for the programmes, as it concerns new programmes. However, he indicated later on that it will go (including TLTROs) in the direction of the size of the ECB balance sheet at the start of 2012. At that time, the balance sheet was about €2700B, whereas now it is €2040B. So, there might be roughly an increase by €700B. If this is reached, it would indeed be a sizeable but not yet broad‐based QE programme. For markets, the expanding ECB balance sheet and the (soon) stable size of the Fed’s balance sheet is important. It suggests further euro weakness.

On the 3‐year ABS programme, Mr. Draghi said the ECB would buy senior tranches of simple and transparent securities. Mezzanine tranches are an option, but only when governments give a guarantee (against credit losses). ABS may have very different underlying assets going from car loans, credit card loans to mortgages and SME loans. Banks are the obvious targeted sellers of such paper, but Mr. Draghi said that also other financial investors could sell ABS to the ECB.
Selling ABS to the ECB enlightens the bank’s balance sheets and thus create space for new lending.

FX markets: Euro weakens

The clearest market reaction came in the FX market. The euro fell sharply. EUR/USD fell to 1.2950, a daily decline of about 2 big figures. The cut in rates, especially the deposit rate, sent the message that the ECB wants to weaken the euro. The upcoming balance sheet expansion in the ECB versus a stabilization of the Fed’s balance sheet will once more emphasize the different orientation in monetary policy on both sides of the Atlantic, something the ECB continues to highlight.

Bonds markets: steepening curve

The lower rates and the QE programmes strengthen the forward guidance that rates will remain low for long. As a consequence, the short end still gained ground with German 2 and 5‐year yield down 5‐6 basis points to respectively ‐0.08% and +0.19%. However, the bold action and increasing chances of another QE programme, if needed, diminish the chances of deflation or a prolonged period of very low inflation. As a result, the 30‐year yield jumped 7.6 basis points higher, while the 10‐year yield increase was more limited, up 1.4 basis points to 0.97%. Strong US eco data may have had some impact too. Eonia should now more often be negative, with the range maybe between ‐5 and +5 basis points.

The ECB decisions are a risk‐on event that supports especially the peripheral bonds. Spanish and Italian 10‐year yield spreads dropped 13 basis points, Irish and Portuguese spreads shed 7 and 9 basis points. Also semi‐core spreads of e.g. Belgium and France narrowed 5 and 4 basis points. The implementation of the ABS programme as a private QE might be considered as a (eventual) precursor for a full blown public QE programme oriented on buying sovereign debt.

Other credit products will benefit too. The ECB action lowers the risks of default. Equities fared well with Italian and Spanish equities outperforming.