ECB: Already longing for more?

ABS program in focus

Will ECB buy also lower rated Greek and Cypriot ABS?

What about lowflation and growth?

Draghi to keep road open for full blown QE?

Economic and inflation developments continue to put pressure on the ECB to ease policy further. Neither we nor the market are looking for fresh measures tomorrow. Last month, the ECB lowered its official rates and announced two new asset purchase programmes, one focussed on ABS and another on covered bonds. Tomorrow, attention will concentrate on the details of these programmes, which will be revealed. Besides that, the focus will be on Mr.
Draghi’s assessment of the current lowflation environment and what further remedies there might be to stimulate the economy and push inflation higher. We expect him to be dovish and keep hopes alive that the ECB will in due time use another big bazooka in the form of a full blown QE program focussed on sovereign bonds. We briefly paint recent developments and discuss Mr. Draghi’s strategy.

Economy stagnates, inflation drops.

Following flat growth in Q2, the economic situation hasn’t improved of late.Measures of business confidence (PMI/EU Commission and IFO) slid further in September. Together with recent hard data, it seems that the economy didn’t grow in Q3 either. Momentum‐wise, there is yet no sign of improvement for Q4. Also consumer confidence deteriorated. For now, there is no real deterioration of the labour market, but labour markets react usually with a lag to changes in economic momentum. There is uncertainty whether the current pause in growth is a soft patch that will be followed by a re‐acceleration of growth or the precursor of a further slide into a renewed if shallow, recession. Very expansive monetary policy, a weaker euro, a quickening of US growth and a less tight fiscal policy point to the possibility of a re‐acceleration of growth, but the situation remains fragile and any additional negative shock might be enough to push the economy into recession.

The August inflation report included some positive signals that seemed to suggest that fears of deflation might have been overdone. The core inflation rose to 0.9% Y/Y and the breadth of the product groups showing negative Y/Y readings fell for the second consecutive month. However, the September flash estimate was a rude awakening. The headline inflation dropped, as expected to 0.3% Y/Y, but surprisingly enough, core inflation also fell but by 0.2%‐ points to 0.7% Y/Y matching the all‐time lows. We will closely look at the final report (which contains greater details), but the odds are that the deflation risk remains well and alive for longer. The weaker euro may bring some solace, but energy prices and the growth standstill, which increases the output gap, continue to restrain prices across the board.

Inflation expectations fell sharply in August, raising the alarm bells in Frankfurt. Mr. Draghi in a high key‐note speech in Jackson Hole pointed to these declining inflation expectations (see graph) and the tendency of a deanchoring of inflation expectations. The ECB had always pointed to well‐anchored inflation expectations and thus this development raised fears that the current low inflation could turn to more permanent undershooting of its inflation objective.

Draghi on the road to QE?

It is legitimate to contemplate whether the emphasis on inflation expectations is not a deliberate attempt to prepare the ground for a full blown QE program focussed on sovereign bond purchases and to keep the euro weakening. Inflation dropped to ‐0.6% Y/Y in 2009 and core CPI reached the 0.7% Y/Y low already three times before. Energy prices are also now an important driver behind low headline inflation. There is little strong evidence about the kind of relationship that exists between inflation and inflation expectations. The ECB staff barely changed its inflation forecasts in September. It expected inflation to very gradual move higher. Despite, Mario Draghi himself turned the attention to low inflation.

Before completing our reasoning, we should highlight another element. In September, Mario Draghi suggested that over time, the ECB balance sheet could expand by €1Tr to €3Tr, matching the highs reached in 2012 when the LTROs were implemented. Now, Draghi expects to pump up the ECB balance via the TLTROS and ABSPP & CBPP3.
However, the arithmetic doesn’t lead to €1Tr expansion.
Indeed, the take‐up at the first TLTRO amounted to only €82.6B. Admittedly the second auction should be more successful, but unlikely to top €200B. There are still more auctions in the next years, but unless bank lending to the private sector would mushroom, unlikely given the growth outlook, the extra TLTROs won’t contribute that much to the size of the ECB balance sheet. Regarding the ABS programme, the ABS market is not very big and large part of the existing ABS are now already used as collateral.
Regarding the covered bond program (CBPP3), the CBPP2 was prematurely aborted because of liquidity issues. So, also the size of these two programs should be limited (€150B?). Against these operations that add to the size of the ECB sheet, the €148B of outstanding SMP bonds will gradually be redeemed shrinking the balance sheet.
Similarly the €320B of outstanding LTRO loans will have to be repaid by banks by early 2015. Taking all these factors together, the ECB balance sheet will only increase very modestly falling well short of the €1Tr aim put forward by Draghi.

In a zero rate world, the size of the balance sheet of the various central banks is used in markets as a benchmark for the stance of monetary policy. The US balance sheet will soon stabilize, but if the ECB doesn’t succeed to pump its balance sheet up, the weakening of the euro may stop or even be partially reversed. A weaker euro is probably the most powerful weapon to push inflation higher and generate some growth.

The combination of low inflation, falling inflation expectations and an obvious shortfall on its attempt to pump up the balance sheet, raises expectations that the ECB will supplement current measures by large scale government bond buying. This might be exactly the objective of Mr. Draghi, managing market expectations.
However, once entering that venue, Mario Draghi might at some point be obliged to walk the talk. For now, he keeps the ambivalence about whether he will deliver, as especially in Germany there is resistance to the idea of buying government bonds. Of course, it might be his plan to create the circumstances (an inadequate expansion of the balance sheet through other means) in which a QE decision becomes the “inevitable” answer.

ABS plan key information

The details the ECB provides on its ABS plan are important to gauge its impact. , the ECB wants to buy private sector assets via the bundling of loans known as asset backed securities. There are a lot of questions marks around this programme. First of all, will the ECB buy more than the “safe” senior tranches? The ECB wants EU governments to guarantee the mezzanine tranches and that’s something Germany and France are not willing to do. The issue will only be discussed at the Eurogroup meeting at the end of October. An alternative plan is that the EIB guarantees the mezzanine tranches. Second, will the ECB be able to buy Greek and Cypriot ABS tranches? An FT article reported that Draghi is willing to do so but again runs into German resistance. The problem is that these Greek and Cypriot tranches have junk ratings as the maximum rating for ABS loans is mostly similar to the country’s rating (both B‐ at S&P). Draghi’s rationale goes that it would have a significant impact in these countries as it frees up loads of capital. A final issue is the depth of the ABS market. The size of the market currently stands around €650B. Many doubt that the combination of TLTRO’s and the ECB’s buying programmes (ABS & covered bond) can expand the ECB’s balance sheet by €1000B. (see above).

Conclusion

For all these reasons, markets remain doubtful that Mr Draghi can easily deliver on the promises he has made. Critically, however, the price action in interest rate and fx markets suggests a belief that he will find some way of implementing a monetary stimulus. Tomorrow’s meeting should tell us if Mr Draghi can readily overcome significant technical hurdles to easier monetary conditions or if a further deterioration in the Euro area economy will be needed to prompt ‘nuclear’ action.