As Market Awaits "Santa" Draghi, The ECB Is "Chasing Its Own Tail"

“If the ECB merely does on 3 December what is effectively priced by the market, we could collectively wake up on 4 December feeling a bit deflated, like a child discovering on Christmas day that his parents ‘only’ gave him what he/she had asked for, without the ‘little extra’ that would have kept him/her smiling all day long,” BofAML writes, in a colorful new note ahead of next week’s highly anticipated decision from the world’s second most important central bank. 

As horrifying as it may be to imagine a bearded Mario Draghi creeping down your chimney in the middle of the night before drinking your milk, eating your cookies, and leaving gifts in your living room, the characterization of the ECB as a kind of Santa CB that always over-delivers at key policy meetings is probably a fairly helpful way to conceptualize Draghi’s strategy.

Indeed he seems to be far more adept than his counterpart in the US at jawboning, signaling, and delivering. That is of course not to say that what the ECB is doing is working - it isn’t,  as evidenced by an increasingly entrenched disinflationary impulse and still lackluster growth - it’s just to say that Draghi seems to understand quite well what the market wants to see when it comes to perpetuating the lunatic pursuit of NIRP, QE, and other aberrations of the Keynesian kind.

Next week, Santa Draghi faces what may be his biggest challenge yet: over-delivering in the face of sky high expectations. “Not only does the market aggressively price the next layer of accommodation, but it also expects -- demands -- to be surprised to the upside,” BofAML notes, adding that the sell side penguin brigade’s consensus “seems to stand around a 10-20 bps cut in the deposit rate, an extension in QE of sixmonths and no or small expansion in the pace of buying.” 

When it comes to the depo cut, expectations were ratcheted up late in the week when Reuters reported that the ECB may be considering a two-tiered system for application of NIRP to reserves. “Officials are discussing a split-level rate,” Reuters said, a “contested step [that] would impose a higher charge on banks depending on the amount of cash they deposit with the ECB.” Doing this would put the ECB more in line with the SNB and could thereby diminish what might otherwise have been an outsized impact on the EURCHF cross but more importantly, it could give Draghi room for a larger cut. "The level of negative rates in Sweden might be the more appropriate benchmark for the ECB. Even though the Riksbank’s official deposit facility rate is at -1.10%, the mechanics of the implementation of their monetary policy implies that the effective deposit facility rate in Sweden is at best 10bp lower than their main repo rate which is currently at -0.35%. Hence, we view that the potential range for the cut to the depo rate in the Eurozone could be 15bp – 25bp," Deutsche Bank says, in an attempt to venture a guess at "how low they can go" so to speak.

Here's a look at who suffers the most under NIRP (i.e. who's getting hit on deposits):

And here’s BofA with a breakdown of the options: 

Market chatter focuses on the "big options", where the depo rate would go very low, beyond -40bps. This raises quite a lot of technical problems. As we have argued, given the strong rise in banks' excess reserves in connection with QE, when the depo rate becomes large, the impact on banks profitability cannot be ignored, with risks that they cut the overall size of their balance sheet rather than "lend more". What are the mitigation options then? 

  1. Take the refi rate down as well (to negative territory) to keep the corridor tight. The drop in the average return on bank assets would thus be partly offset by a lower average cost of funding. This is technically doable (Sweden has done it). The message would be extremely strong -- there would no longer be such thing as a lower bound for the Refi rate -- but we note that Draghi so far, when discussing policy rates, has only mentioned the depo explicitly. Our view is that the reception by public opinion in "hawkish countries" would be very negative. 
  2. Apply the cut in the depo rate to only a fraction of reserves. This can be done either by increasing the reserve requirements at the ECB, remunerated at the refi rate (but, therefore, reducing excess liquidity), or by a creating an intermediary rate (between the refi and the new depo) that would apply to excess reserves below a certain level. Note that the distributional consequences differ if the ECB chooses this cut-off level based on volumes or in proportion to each bank's balance sheet (small banks would be better isolated from the depo cut in the first case). 
  3. Go Swedish. In Sweden, the deeply negative depo rate is largely cosmetic, since banks can park their cash on fine-tuning operations launched by the Riksbank, at a rate close to the equivalent of the refi. The volume of reserves parked at the deposit facility is negligible. This explains why, in Sweden, money market rates and the yields on short-dated government securities are closer to the refi than to the deposit rate. 
  4. The report published by Reuters on 25-Nov suggested that the ECB was exploring the second solution. While our understanding is that it is only ONE of the many options on the table, we find it positive that the ECB is at least thinking of cushioning the blow to the banks were it to go for a "shock" solution. This may explain why the equity market started responding positively to expected additional ECB accommodation, since it would make it unambiguously supportive (lower exchange rate, lower interest rate and no or little drawback for the banks)

As for the implications of a depo rate cut on the availability of increasingly scarce PSPP-eligible paper, there's a certain degree to which Draghi is, to quote Blooomberg, "chasing his tail." 

"The ECB risks running to catch up with itself on this and won’t be able to buy any bonds at the front end of the core-market curves," Richard McGuire, head of rates strategy at Rabobank International warns. The argument is simply this: as the market continues to price in further rate cuts, extensions of QE, and increases in the pace of PSPP bond buying, yields on core paper will be driven inexorably lower, quickly negating any benefit the ECB would have gotten vis-a-vis the expansion of the purchase-eligible universe of bonds. As Bloomberg puts it, "the institution may find itself in a vicious circle of having to keep cutting rates to free up more securities, only for bond investors to keep on pushing yields down even further."

“Some suggest a depo rate cut may ease the scarcity, with the amount of quantitative easing-eligible bonds above the rate increasing, but we suspect the opposite may be the case,” Christoph Rieger, Commerzbank’s head of fixed-income strategy in Frankfurt told Bloomberg. 

Obviously, the problem would become more acute should the ECB decide to hasten the pace of asset purchases (i.e. expand QE beyond the current monthly quota in addition to extending PSPP's duration). Even with the higher issue cap (raised to 33% from 25% at Setember's meeting), the ECB still has a problem when it comes to sourcing some core paper and that problem will be exacerbated if Draghi picks up the pace. "On the size of the extra buying, the ECB at this stage has some constraints related to the capital key, and running out of Bunds, if they only buy up to 33% of issues," Citi notes. 

Citi also has a useful graphic which helps to delineate what the options are in terms of various combinations of increased bond buying and program duration extension (the blue boxes represent Citi's baselines):

Of course Draghi could always just drop the depo rate floor constraint on PSPP altogether. As Citi notes, "the rationale for the floor on buying at the deposit facility rate owes to loss mitigation by core central banks." In other words, buying at negative rates guarantees core CB losses when the bonds are held to maturity and in the meantime, buying at the top means that if something should go "wrong" and the "market" (or whatever is left of it) begins to price in risk (i.e. if yields start to rise), the paper losses will be enormous. "Given the rate cut risk to even deeper levels of negative – the Bundesbank is unlikely to support purchases below this deeper negative because the losses are likely to be greater once the ECB does hike," Citi adds. Be that as it may, here's a look at what dropping the depo constraint would mean in terms of eligible paper:

"For the current eligible universe in Germany removal of the yield floor will increase the eligible universe by EUR 120bn which could allow the ECB to continue purchases, at the current pace, for an additional 11 months, i.e. until September-18 if we consider the cumulative impact of all the measures discussed above," Deutsche Bank adds.

Finally, here is Deutsche Bank's full breakdown of the ECB's options and how to trade the various policy combos:

As you can see, this has become terribly convoluted. Draghi's reaction function must take into account a bewildering array of factors all of which influence one another in a kind of nightmarish Keynesian kerfuffle which is complicated immeasurably by the fact that whatever the ECB does will have serious implications for the Riksbank, the Nationalbank, the SNB, and the Norges Bank, not to mention everyone's favorite, the BoJ. Furthermore, the greater the "over-delivery", the wider the policy divergence with the Fed.

Interestingly, analysts seem to believe that quite a bit of what the ECB is likely to announce is already priced in. To be sure, Draghi became the king of jawboning after, to quote BofA, "single-handedly stopping the sovereign crisis" in 2012 by talking Spanish and Italian sovereign yields back from the 7% precipice.

If it's all priced in and tough talk is enough to work market "miracles", then why not just stop the insanity and do nothing at all? Oh, that's right... it's all about over-delivering for the sake of the "market", which has now been reduced, in the minds of sellside strategists, to the equivalent of a spoiled child on Christmas morning.