• Trough. The downward revisions to GDP in the eurozone have continued at a brisk pace recently, since it is now considered a done deal that the recession deepened further in the first quarter – in contrast to the US, where the rate of contraction slowed marginally. The across-the-board improvement in the leading indicators, however, suggests that the pace of the recession will at least slow appreciably in the coming months (pages 5-6).
  • Tension. The situation on the credit markets, however, remains less hopeful. The money supply growth has slowed more strongly than expected and lending standards are being tightened further, albeit to a lesser extent (cf. chart). This will prompt the ECB to lower its key interest rate to 1.0% in May – presumably for the last time.
  • Measures. In addition, to avert a credit crunch and deflation, the Governing Council members will – after a lively debate – probably agree at least to extend the unlimited repo transactions up to one year. While other unconventional instruments cannot be ruled out, they will probably only be considered if the situation on the credit markets escalates further (pages 2-4).
  • Trailblazer. The Fed already reached the floor for the Fed funds target rate at the end of last year, and since then it has stepped up its outright purchases of securities to stabilize the particularly hard hit US credit market – so far to the tune of close to USD 500 bn. And an additional USD 1¼ trillion are planned. Moreover, if required, the Fed signaled its readiness to further extend the purchase program (p. 16).

Further topics:

  • Swine flu: A threat mostly to crowded cities (page 7).
  • Data outlook: EMU: Industry continues to contract; US: Wave of layoffs continues (page 9).
  • Market outlook: Uncertainty amid stress tests and ECB (page 17).

ECB – First steps in “unconventional” territory.

  • At the May meeting, the ECB will cut rates to 1.0%, will pledge to keep them there for a long time, and will extend the maturity of its unlimited repo operations until the 12- month maturity.
  • Recent evidence shows that on the growth front the freefall is probably coming to an end, but the credit market remains impaired and the monetary analysis pillar will keep the ECB in alert mode.
  • The debate within the Council will remain pretty lively both in terms of the final level of rates and what other unorthodox measures to avoid a credit crunch and/or a deflationary spiral are appropriate.
  • Hence, it is likely that Trichet will tell us that other readyto- use instruments are in the ECB’s toolbox and that they stand ready to employ them if lending deteriorates further during the summer and/or inflation expectations start declining in a worrying manner.

The monetary analysis sends warnings

The run-up to the crucial May ECB Governing Council (GC) meeting has been pretty intense with several GC members outlining their views on the final level for the refi rate and on the most appropriate unconventional measures for the euro area at this juncture. Furthermore, Bini-Smaghi started the debate on Tuesday night in Geneva: one has to think about an exit strategy both for rate and unconventional policies.

On the data front, different surveys showed the first tentative signals that the real cycle may be stabilizing. To the contrary, now is the phase when monetary analysis is sending the most dovish signals and will do so for some time. In March, the pace of money growth slowed further to 5.1% from the previous 5.8%. Loans to the private sector grew only 3.2%, more than one percentage point lower vs. February’s 4.3%. The closely-watched growth in loans to non-financial corporations eased further to 6.3% from 7.7%. Loans to households are at a standstill and grew only 0.4% y-o-y. On a monthly basis, there is a visible contraction in almost all components.

Also the ECB Bank Lending Survey (BLS) for the first quarter of 2009 confirmed an impaired credit market. Credit standards are stabilizing somewhat but remain at very tight levels. Both demand and supply factors will result in restrained lending throughout 2009 and possibly beyond. Let’s have a look at the details:

Enterprises: In Q1 2009, the net percentage of banks reporting a tightening of credit standards for loans to enterprises declined to 43% vs. 64% in Q4 2008. Though off the peak, this level signals a significant degree of additional net tightening of already tight credit standards. Confirming the trend in place since the beginning of the crisis, the tightening of lending standards remains stronger for loans to large enterprises. Banks continued to report that expectations for general economic activity and the firm/industry specific outlook are the main drivers of the tightened lending standards, though the importance of these factors abated somewhat versus the previous quarter. Concurrently, the impact of banks’ cost of funding and balance sheet constraints on lending moderated somewhat, but remained at a relatively high level. With respect to non-interest rate changes, collateral requirement and the size of credit lines contributed the most to tighter standards. However, in all cases the net percentage of banks reporting tighter terms and conditions declined from Q4 2008. Loan demand kept declining, but at a somewhat slower pace than in Q4 2008 (-33% vs. -40%). Unsurprisingly, financing needs for fixed investment, a very good gauge of corporate investment trends, is still in free-fall (-62% vs. -60%). Turning to expectations, banks envisage an easing in net tightening in Q2 2009 (to 28%) and less negative loan demand (-12%).

Households: The net percentage of banks reporting a tightening of credit standards for mortgages eased significantly, from 41% in Q4 2008 to 28%, on the back of expectations on general economic activity and housing market prospects. Quite interestingly, the cost of funding and balance sheet constraints played a much smaller role in driving net tightening (from 22% to only 7% of banks). The pattern of housing finance was mirrored in the consumer credit sector, where the net percentage of banks reporting a tightening of credit standards moderated somewhat to 26%, down from the peak of 42% reached in the previous quarter. The main factors behind the further increase in net tightening were again banks’ risk perception and the creditworthiness of consumers. Net demand for housing loans remained negative, but more than halved compared to the previous quarter (-30% from -63%), with housing market prospects and deteriorating consumer confidence being the main reason for negative net demand. Net demand for consumer credit and other lending remained negative, albeit less so than in the previous quarter (-34%, up from -47%). Expectations on future lending provide some ground for cautious optimism: credit standards for house purchases are expected to tighten again (19%), but the net percentage is lower than actual tightening recorded in Q1 (28%). Similarly, credit standards for consumer credit and other lending to households are expected to tighten by 20% compared with the actual net tightening of 28% in Q1 2009.

The Quantitative Easing campaign starts

As we pointed out right after the April press conference, the May ECB meeting promises to be a key signpost in monetary policy, at least for the current year. In the intra-meeting period, the debate has heated up and we now have a clearer picture of what alternatives will be on the agenda on May 7. For the sake of simplicity, we will label them the “Orphanides package”, the “Nowotny package”, and the “Weber package”. Orphanides would like to raise the stakes and, while keeping the banking system center-stage, he is in favor of bringing the refi rate below 1% and start buying corporate debt from banks in order to unclog banks’ balance sheets and ease financial conditions for firms. Nowotny has spoken for those who support one last 25bp cut but think that the purchase of commercial paper and corporate bonds would be a “sensible and efficient measure” given that it focuses directly on the supply side of credit. Unsurprisingly, Weber will lead those willing to adopt a more cautious approach consisting of stopping at 1% (coupled with a long-term commitment to the rate outlook), and – as regards unconventional measures – only extending the unlimited refinancing operations up to 12 months. In this framework, and using Weber’s words, asset purchase should “very much take a back seat”.

In a nutshell, we think that Weber has a point regarding the final level of the refi rate, whereas something more aggressive has to be done to ease financing conditions. Clearly Weber is right when saying that with the depo rate at its 0.25% trough, bringing the refi below 1% risks paralyzing an already-impaired interbank market, as narrowing the corridor further risks wiping away the incentive for intra-bank lending (to this extent, keep in mind that already in May the corridor will be narrowed from the current 100bp). Orphanides replied that – given that the Euribor decline cannot last indefinitely – a trend inversion in money market rates has to be avoided; hence, the need to lower the refi rate further may arise. However, one of the key takeaways of Weber’s speech in Hamburg is the commitment to a low level of the refi rate in the medium term. This is of striking importance, especially in light of the famous Weber interview with the Financial Times a few years ago, where he more or less claimed that too much policy guidance may be counterproductive. He goes on saying that the cut in the refi rate, the commitment to keep it low for a while, and the extension of repo operations should be considered part of one (unorthodox) package the ECB is employing to face the challenges ahead. This is what the ECB can be expected to deliver next week. Indeed, it is the package for which there are clear chances that an agreement can be reached – at least by consensus – within the council.

However, we fear that this won’t suffice and that eventually the ECB may be forced to expand its balance sheet via an asset purchase program aimed at making the banks’ deleveraging smoother in order to keep the credit tap open. Weber is right when, citing a recent Bundesbank study, stating that 80-90% of the ECB easing has been passed on to short-term lending interest rates. But, as we repeatedly stressed, now the problem is the medium to long-term financing and unless banks are able anew to fund themselves at longer maturities, they won’t go beyond a certain level of maturity mismatch on their balance sheets.

Let’s briefly recap the Quantitative Easing options on the table, as well as their pros and cons:

  • Extend the maturity of refinancing: This is a done deal, most likely to 12 months. It will be announced in May and will alleviate banks’ fears to get liquidity beyond the short term. Bini-Smaghi labeled this measure as “indirect credit easing” and praised the results it has delivered so far in terms of low money market rates, and tentative signs of recovery in intra-bank lending.
  • Purchase of commercial paper: This measure certainly would help to ease some short-term financing strains, but commercial paper is relevant only in some countries. If “one size fits all” holds true, this shouldn’t be a measure worth considering. However, it has been flagged by a number of Council members and certainly has a few supporters.
  • Purchase of corporate bonds: It would certainly help overall financial conditions via narrower spreads. However, the backbone of the economy, small and medium-sized enterprises, would be left out unless these assets were bought from banks pledging to reinvest those funds in traditional lending.
  • Purchase of financial bonds and/or securitized assets from banks: This remains our favorite unorthodox measure. It keeps the banks at the center of the policy framework; it would free banks’ capital necessary to avoid a credit rationing; it would re-open the securitization market, which in the past has helped the credit flow also in times of monetary tightening; it would make deleveraging easier to digest. The big con is the valuation of some assets (ABS) and the consequent exposure of the ECB to the criticism of becoming a massive risk taker.
  • Purchase of government bonds: The ECB cannot do this directly from sovereigns. Buying govies in the secondary market risks triggering an undesired misalignment in govie spreads and it is not viable from a political standpoint. Plus, the ECB does not want to give the impression that it is funding public debt. I genuinely think the ECB is not yet contemplating buying government bonds, because they still think that deflation is a somewhat remote possibility. If the need to flatten the yield curve in order to avoid a deflationary spiral arises, chances of such an option will arise in my view.
  • Purchase of equities: Too risky for the ECB’s traditional stance and of doubtful effectiveness.

As a matter of fact, Weber's and Bini Smaghi's remarks represent a clear indication that an agreement upon asset purchases won’t be reached soon, at least not at the May meeting. Hence, chances that we will end up with “Weber’s package” in May are high. However, with inflation entering negative territory and a difficult-to-foresee reaction in inflation expectations – to this extent keep an eye on the Survey of Professional Forecasters' (SPF) 5-year inflation forecast as the Council pays a lot of attention to it – the May decision may well end up being only the first step. The jury will be out for some time but the good news is that the ECB focuses on monetary analysis, hence will remain on high alert, with different instruments in its toolbox ready to be employed.