The ECB set off on the slippery exit path
with the right combination of confidence and caution. It has caught the market
off guard with the decision of holding the last 12 month LTRO at variable rate,
while at the same time giving a very clear indication of both the logic
underlying the exit strategy and of the next concrete steps—for the time being,
the ECB looks ahead of the curve and in control. Setting a variable rate on the
last 12 month LTRO while maintaining a fixed rate and full allotment for all
LTROs in Q1 represents a careful balancing act, designed to discourage carry
trades while guaranteeing full support to weaker banks and avoiding a sudden
rise in funding costs for governments (a question on Greece was a timely
reminder that this remains an important issue); and to maintain ample liquidity
while shortening its duration, gaining more flexibility to drain liquidity
faster if and when needed. The ECB’s trademark distinction between enhanced
credit and liquidity support on one hand and monetary policy stricto sensu on
the other returns center stage: Mr. Trichet was emphatic in noting that the
decisions on liquidity simply reflect improving market conditions and in no way
signal a prospective hardening of the monetary policy stance. Indeed, the
assessment of economic and monetary conditions as well as the new staff growth
and inflation forecasts confirm that there is still no compelling argument for
hiking rates. Bottomline: expect a contained demand at the 12 month LTRO, but
short-term market rates will remain very low through Q1 and rise gradually
towards the Refi thereafter. The Refi, however, will remain at 1.0% throughout
next year.
The ECB outlined the first steps of the exit strategy, catching the market partially off guard: The next and last 12 month LTRO, on 16 December, will be with full allotment but a variable rate given by the average minimum bid rate of the MROs over the life of the operation. The last 6 month LTRO will be held on 31 March 2010, and will be with full allotment and fixed rate, as will the regular 3 month LTROs already planned for Q1 2010..
These decisions represent a careful balancing act, which should allow the ECB to limit the scope for speculative carry trades without putting the weaker banks at undue risk, and allow the ECB to shift the weight of the liquidity to shorter term operations, so as to be able to drain liquidity more quickly if and when appropriate.We have been highlighting for some time that one of the toughest challenges for the ECB is the emerging dichotomy within the eurozone banking system, with some banks having regained near-normal market access and others still overly dependent on the ECB. Setting a variable rate on the 12 month LTRO goes some way towards addressing this problem: it discourages banks from stocking up on 12 month liquidity for either precautionary or speculative (carry) reasons, while at the same time guaranteeing unlimited access to those which are really in need of liquidity to manage the year-end transition.
Setting a variable rate on the 12 month operation while keeping a fixed rate with full allotment on the other LTROs planned for Q1 guarantees ample liquidity for the next few months while shortening its duration. This will give the ECB more flexibility to move from April onwards, after having observed market developments during the next four months. It is a call option: depending on conditions, the ECB could extend unlimited cheap liquidity further, or it could start draining it at a quicker pace without the burden of an excessive overhang of 12-month liquidity sloshing around till year-end.
This gradual approach is also calibrated to slowly reduce the fuel supply for carry trades without however triggering a sudden rise in funding costs for governments. The abundant liquidity provided by the ECB has helped support demand for government bonds, thereby containing the cost of financing budget deficits—a particularly important factor for those governments which are struggling with ballooning financing requirements. The ECB is well aware that the adjustment on that front, while needed, will also be gradual.
The ECB has also re-emphasised its trademark distinction between liquidity management and enhanced credit support on one side, and monetary policy stricto sensu on the other: Mr. Trichet was at pains to stress that the exit strategy decisions were not meant to convey any signal on the likely path of the main policy rates. In other words:
- In line with the observed improvement in market conditions, the ECB starts to gradually,slowly and cautiously phase out the extraordinary liquidity and credit support measures;
- The decision to set a variable rate on the 12 month LTRO is designed to be neutral: the rate will evolve following market conditions rather than influencing them with a particularly low (the 1% of previous operations) or high rate (in case of an arbitrary spread to the refi);
- The Governing Council unanimously sees interest rates as currently appropriate, and givesno indication that could suggest an increase in the foreseeable future.
Therefore, we stick to our call for a Refi rate on hold throughout 2010.
While the ECB is gradually moving to reduce the fuel for carry trades, concern about a possible resurgence of asset price bubbles is in the background, but not a major factor at this stage. Trichet noted how the Dubai World episode was a notable reminder that a relatively small event could still have a significant broad market impact, a reminder that the global financial situation remains fragile and volatile. He did not however point to evidence of froth in financial markets
