Goldman Warns 'Don't Expect Large QE' From ECB In June
While France's Hollande demands action - amid his country's "political earthquake" this weekend - Goldman warns investors should not expect any signal that the Governing Council is pondering in earnest a large-scale asset purchase program. Goldman expects the ECB to lower policy rates by 15bp at the June meeting and the announcement of targeted credit easing measures, probably in the form of a vLTRO as Draghi warns "the potential for a negative spiral to take hold between between low inflation, falling inflation expectations and credit, in particular in stressed countries."
Via Goldman Sachs,
Bottom line: We expect the ECB to lower policy rates by 15bp at the June meeting. We also expect the announcement of targeted credit easing measures, probably in the form of a vLTRO. We do not, however, expect any signal that the Governing Council is pondering in earnest a large-scale asset purchase programme.
First-quarter GDP disappoints, but sentiment remains consistent with a "gradual recovery"
First-quarter Euro area GDP grew by 0.2%qoq, a bit slower than what the ECB (and we) had been expecting. Business surveys and monthly data - which we summarise in our Current Activity indicator - had suggested a somewhat faster expansion (see Exhibit 1). Maybe more worrisome from the perspective of the ECB was the rising divergence signalled by the first-quarter GDP figure: while the recovery progressed nicely in Germany and Spain, France barely managed to grow and Italy recorded another small decline in economic activity, after a small expansion in Q4 last year.
Quarterly GDP data can be quite volatile and we continue to believe that the Euro area economy will gradually gain further momentum throughout this year, based on an easing in financial conditions, less fiscal austerity and an improving external environment. But while we think that the Q1 GDP print should not be taken at face value, it is also the case that the latest data out of the Euro area have been mixed. For example, the flash composite PMI was broadly flat in May, but the French and German national business surveys recorded a decline in May. At the same time, Italian business and consumer confidence improved further. In sum, at this point there is no reason for the ECB to change its baseline scenario of a "gradual recovery", but the ECB is also likely to continue to view the risks for the growth outlook as being to the downside.
Inflation rebounds in April but uncertainty about underlying momentum remains
Euro area inflation rebounded to 0.7%yoy in April after +0.5% in April. Inflation excluding energy and unprocessed food also rose from 0.9%yoy in March to 1.1% in May; core inflation excluding energy, food, alcohol and tobacco rose to 1.0% after 0.7%. Looking through the monthly volatility, this suggests that core inflation was broadly stable over the last six months (Exhibit 2).
The ECB (and we) expect inflation to stabilise around the current level - we are forecasting +0.6%yoy for May - before starting to rise back to 1% by the end of the year. This expectation is based on two main assumptions. First, the negative effect from the energy component on inflation is coming to an end (around 60% of the decline in headline inflation since 2012 can be attributed to the energy component). Second, as the recovery progresses, the underlying inflationary pressure will slowly build again, particularly in Germany. The main risk to this forecast seems to be at this point that the recovery in France and Italy does not take hold.
Mr Draghi will also present the updated ECB staff projections at the June press conference. Several Governing Council members have referred to these new forecasts as an important input for their thinking and any decision about a change in the monetary policy stance. Exhibit 3 summarises the "technical assumptions" on which these projections are based. Compared with the March projection, the oil price now shows a somewhat higher path. The exchange rate is also expected to be slightly higher over the forecast horizon, while interest rates have come down significantly over the last three months. One further noteworthy change compared with March is the introduction of a minimum wage in Germany by 2015, as the law on this came into force only in April.
Exhibit 4 shows our best guess of what the new staff projections could look like. We expect growth for this year to be revised down on the back of the weaker first-quarter GDP figure. The adverse effects from the higher oil price and exchange rate should be broadly offset by the decline in interest rates. Beyond this year's forecast we see little reason for the staff to change its growth forecast.
With respect to inflation, the staff is likely to revise down this year's forecast, mostly on the back of somewhat lower than expected inflation prints in the last three months. The higher oil price forecast would argue for a small upward revision of the inflation forecast, while the exchange rate would suggest the opposite. Taken together, both effects should broadly neutralise each other. Lower yields have only an indirect effect on inflation via stronger growth. But we doubt that the staff will revise their growth forecast upwards, also implying that there is no change to the inflation forecast on the back of the decline in interest rates. With respect to the German minimum wage, we expect the staff to take a cautious view, seeing it rather as an insurance against a downside surprise for 2015 than a sufficient factor to revise the 2015 forecast upwards.
Still feeling "comfortable to act"
President Draghi signalled clearly at the May press conference the Governing Council's intentions to reconsider the appropriateness of the policy stance and its willingness to act should the Governing Council come to the assessment that the downside risks to inflation had increased. In that context, we think the updated staff projections will provide sufficient grounds for the GC to ease policy further. While it is true that we expect a downward revision only for 2014, Mr Draghi has stressed many times that a low inflation rate by itself poses a risk to the inflation outlook as it may lead to a downward shift in expectations (see, for example, his speech in Sintra). It is also noteworthy in that respect that the latest ECB survey of professional forecasters shows a downward move for the '5-year-ahead' inflation forecast to 1.8%, the first reading of this long-term forecast below 1.9% since 2001.
With respect to 'conventional' measures, we expect the ECB to cut policy rates by 15bp, implying that the deposit rate will be a negative -15bp. A bigger cut seems unlikely. Indeed, there is a risk that the GC may decide to cut only by 10bp due to concerns about the adverse effects on the banking system from a negative deposit rate (for a detailed discussion of this topic, see here).
Focus to be on credit easing this time, not provision of liquidity
There is more uncertainty as to the extent to which the GC may also announce further 'non-conventional' measures. Not least because of statements from several GC members, we now think that it is more likely than not that additional targeted credit easing measures will be announced. We see two main options for such targeted credit easing measures. First, the ECB may offer a 'conditional' vLTRO. Second, the ECB may announce a purchase programme for specific financial assets that have a direct link to credit creation in the corporate sector. We view a vLTRO as more likely at this point.
One obvious question with regards to a vLTRO is under what conditions it would be attractive for banks to borrow from the ECB, given that there is still a significant amount of excess liquidity in the system and banks are repaying reserves borrowed under the two previous 3-year vLTROs. For one, the banks that are repaying the excess liquidity are not necessarily the same ones that have borrowed these reserves. More importantly, by offering a very long maturity, a VLTRO may in any case be attractive for banks. A vLTRO with a 4-year maturity, for example, could be a quite attractive funding source for banks. Another crucial determinant of the relative attractiveness of a vLTRO targeting the corporate sector is the haircut the ECB would apply to the collateral posted. The more 'generous' these haircuts are, the more attractive borrowing becomes. Unlike in the case of earlier vLTROs, the focus will not be on providing banks with liquidity/refinancing, but on credit easing, i.e., a favourable pricing of the credit risk. Overall, the ECB should be able to make a vLTRO attractive enough to ignite sufficient interest among banks. Indeed, we think the ECB would want to limit the overall size of such a vLTRO.
There are several potential ways for the ECB to ensure that this funding is indeed used to expand credit to the corporate sector. The ECB could demand that only new corporate loans can be used as collateral. There are some non-trivial technical issues when it comes to enforcing the conditionality of the vLTRO and this may imply that the implementation could take some time. But in our view these problems are not insurmountable and we think the preparatory work at the ECB has progressed sufficiently to be able to announce such a measure in June, although the implementation may take place later. It is also possible that a vLTRO could be offered on a rolling basis and not only at a fixed point in time. This would allow banks to refinance any new loan made throughout a certain period.
The other option for the ECB to stimulate credit creation would be to announce a purchase programme for ABS based on corporate credit or even SME loans only. Such a programme, although likely to be small in size, could work as a catalyst spurring market activity in this segment of the financial system. The ECB has for some time now been trying to facilitate the functioning of the ABS market via its ABS loan-level initiative. An ABS purchase programme would only be the next natural step in this effort. One main critical point in any ABS purchase programme would be the credit risk the ECB would face with an outright purchase. To be effective, such a programme would necessarily imply that the ECB is willing not to be fully compensated for the credit risk. But the degree to which this credit risk should be absorbed by the ECB (and therefore the Euro area tax payer) is likely to be contested among GC members. One possible solution to this problem could be if each national central bank were to set up its individual programme, with the credit risk not shared across the whole Eurosystem.
Another possible liquidity measure that has been discussed by GC members is an end to the sterilisation of the liquidity created under the SMP programme. However, we do not think the GC will want to increase excess liquidity when deposit rates are at the same time being pushed into negative territory. Finally, we expect the GC to remain vague with respect to any large-scale asset purchase programme (Fed-style QE). When asked during the press conference about the possibility of an LSAP programme, Mr Draghi is likely to respond that, while this remains a possibility, the GC will want to wait to see how the newly announced measures work before any further steps are considered.
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