Wondering why US and European stocks knee-jerked higher in the last hour - wonder no more. JPMorgan released a report stating they expect the ECB to ease next week, masking some policy changes next week to make TLTROs more attractive and even a slight disappointment in data may trigger sovereign QE (30% chance next week and 50% by year-end).
Of course, the kicker in all of this discussion of QE is that the ECB is already doing it - willing to buy whetever bonds European banks buy via repo agreements (with no haircut) - and with yields already at record lows (or negative) in the face of record-high 'real' financing costs for non-financials, the exuberance appears misplaced.
ECB to ease next week, as QE debate intensifies
- We expect the ECB to make some policy changes next week to make TLTROs more attractive
- These changes are a holding operation, as the ECB assesses the incoming data
- Three data points will be key to watch and even a slight disappointment may trigger sovereign QE
- Apart from the data, the level of opposition on the Governing Council is currently hard to gauge
- We think the chances of sovereign QE are over 30% by year-end and almost 50-50 next year
We now expect the ECB to take some further policy steps at next week’s meeting. The ECB could try to boost the attractiveness of the upcoming TLTROs by cutting the entire interest rate corridor by 10bp, but removing the 10bp spread it was going to charge above the refi rate for the funds and, albeit with a lower likelihood, by increasing the initial allowances above 7% of banks’ real economy loan books (excluding mortgages). This means that banks will be able to lock in even more funding for up to four years at an even lower interest rate of just 0.05%. Making this announcement next week would support take-up at the first TLTRO in mid-September by reducing some incentives to wait for the December tender. In addition, we think that Draghi will make a more definitive statement about what the ABS purchase programme will look like. It is possible that the ECB goes beyond the current plan to buy ABS by also purchasing other private assets, but we are not convinced by this.
The key assumption underlying this new forecast is that sovereign QE remains controversial. If that is true, then the rationale for these relatively small policy changes would be to buy time and allow a bit more wait-and-see, which is something the Bundesbank would be able to support, in our view. For the same reason, the Bundesbank may agree to Draghi ramping up the rhetoric about sovereign QE, for example with a statement that “the Governing Council is unanimous in its commitment to also using unconventional instruments within its mandate, including large-scale purchases of private and public assets, should it become necessary.” This statement would make clearer what unconventional instruments would mean. But, this statement would be more data dependent than the one made in June about possible ABS purchases and the hope would be that it has a significant impact in itself.
But, while we still do not expect the ECB to actually deliver a sovereign QE programme, we think that the likelihood has increased substantially and that things could move very quickly. In particular, we think that the likelihood has increased to almost 50% next year and that it is now over 30% by year-end.
Uncertainty in the data and the Governing Council
To avoid QE, we think that three things need to happen in the data over the next 1-2 months.
- First, the official activity data must realign themselves with where the surveys currently are, with IP in particular needing to bounce in July/August.
- Second, the surveys themselves must start to show signs of stabilization and give hope that they could move higher again.
- Third, inflation expectations in financial markets must at the very least stabilize after the recent falls.
If there is disappointment in these areas, with the second and third probably being the most important, then things could move pretty quickly. For now, our current forecasts are consistent with improvement in the first two areas, which marginally tilts the balance against QE.
We would however emphasize that the level of uncertainty is very high at present, both in terms of how the macro-economy evolves but also in how far the Governing Council has already shifted towards sovereign QE. The first version of Draghi’s speech was certainly very dovish and it did argue that monetary policy should play a central role in boosting aggregate demand. But, it can be read as calling on other policymakers to help boost growth as monetary policy is unable to do it alone. In this sense, it did not clearly signal that the ECB needs to go beyond the measures that it announced in June and that it has yet to implement.
The revised version of the speech of course signals much greater concern and hence a much higher likelihood of sovereign QE, even if other policymakers respond slowly. What prompted this last minute change? We believe it was the combination of signs that growth is weakening and the rapidity with which market-based measures of inflation expectations have recently fallen. In particular, when growth weakens, the ECB tends to be much more intolerant of low inflation, high unemployment and inflation expectations edging lower. Crucially, if inflation expectations fall, it undermines the anchoring of the ECB’s medium-term inflation forecast and would be seen as an expression of doubt in the central bank’s willingness and/or ability to meet its mandate. In our view, this underlies the urgency signalled by the final version of Draghi’s speech and means that the evolution of the data in the near-term will be crucial.
Apart from the data, there is also uncertainty about where the Governing Council currently stands. The Bundesbank is unlikely to have shifted its fundamental concern about moral hazard and its view that governments should do more. But, it has not been fighting the idea that growth is slowing in the Euro area and in Germany, and it will recognise the importance of inflation expectations remaining anchored. It has also recognised recently that many Euro area countries have made progress in the necessary adjustments and it views some of the current headwinds to growth relating to external factors. For this reason, we are less sure how strong the Bundesbank’s opposition to QE would actually be. We do think however that the Bundesbank will at least try to play for time by allowing some ECB easing next week and then hoping that growth improves and that market-based measures of inflation expectations stop falling (after all they are still close to 2%). If the latter happens, it can point to the Survey of Professional Forecasters, which did not show any decline in early August. What is less clear, in our view, is where the rest of the Governing Council stands and whether Draghi is willing to do sovereign QE without explicit Bundesbank support. For sure, Draghi appears to be putting a real challenge to the Governing Council and it is quite clear in which direction Draghi would like to go. As a result, we note that all ECB governors will now have to reveal their real views on the issue.
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These are "market" rates... i.e. what real risk is being priced at away from the hand of Draghi...
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The kicker in all of this discussion of QE is that the ECB is already doing it - willing to buy whetever bonds European banks buy via repo agreements (with no haircut)... so just who is this for?