The ECB and Draghi’s Confidence Game

Source: Bloomberg ECB Interviews, Custom Products

(Picture does not include less active/vocal members [Stournaras, Georghadji, Reinesch, Bonnicim Costa, Makuch)

This is an excerpt from a report ‘Central Banks’ Monetary Policy and Implications for the Yen’ to be published soon

As the ECB Governing Council prepares for its March 10 monetary policy meeting, the rhetoric in anticipation has continued to build. Members are cognizant of the disappointment that arose in the wake of the December meeting where the deposit rate was tweaked down to -0.3% and the QE program was extended for six more months to March 2017, causing the euro (EURUSD) to appreciate by 3%.

Subsequently, the focus has been divided between overseeing the progress on the Euro Zone economy and concerns of a slowdown in China with its relaxation of the RMB trading bands as a possible precursor for devaluation.  Mr. Draghi has also recently been focusing on pressures on European banks arising from weakness in commodity and oil & gas prices as well as a widening in sovereign yield spreads on peripheral countries Italy and Portugal. Though this has had a limited impact on Euribor-OIS spreads, which in fact had expanded more in the US (presumably due to higher exposure to commodity and energy sectors).

Source: Bloomberg, Custom Products

Despite a desire not to disappoint markets, it would seem premature to add to further QQE so shortly after the December meeting and amidst uncertainty revolving around a possible ‘Brexit’ (which has made the ECB’s job easier by dragging down the euro) . Mr. Draghi has rarely enjoyed unanimity in ECB decisions, so recent statements by Draghi of frustration with low inflation, supported unanimously by the five-member ECB Executive Committee, makes further easing in March the base case. In addition, Mr Draghi's apparent impatience to push for action now, may be understood in the context that two of the ECB Governing Council's most hawkish members (Weidmann and Hansson) will not have a vote in the March meeting (the monthly rotation in voting rights on the Governing Council means that only 15 of 19 national bank governors are allowed to vote at each monthly meeting).

Though January Core CPI (P) was only up 1%, it is still the highest since Q4 2012 while the CPI (P) was 0.4%, also the best since January 2012.  (The HICP basket also seems to have been dragged down 40bps by a heavy 15% weighting in transportation). Still, the PPI (Producer Price Index) in December continued to be weak at -3%. Q4 GDP maintained a positive trend, up 0.3% MoM and 1.5% YoY. While provisional February PMI numbers announced earlier this week, between 51.0 and 53.0 disappointed; though still comfortably above contraction levels.

Several Governing Council hawks (Merch, Jazbec, Weidman) have continued to  warn this month that the council not be seen as being reactionary by trying to address what could be temporal moves in crude oil prices.  While the doves (Villeroy, Visco, Constancio) reiterated that the ‘deflation battle was not over’ and that ‘sometimes aggressive action is necessary before inflation falls further’.[1] Thus there is a desire to be pre-emptive as it is feared that inflation could fall further from 0.4% in January, possibly testing test zero around June, as 5-yr forward inflation swaps have fallen to 145bps from the 170bps level as of the December meeting (though this is an envious level for any BOJ member who is looking at 5-yr forward inflation expectations of 10bps).

Mr Coeure, the former French Treasury  Deputy General director, will likely continue the conciliatory role, trying to build consensus with the undecideds (Nowotny, Likanen, Rimsevics). Especially, Mr. Likanen, who was previously opposed to further easing but has recently shown a willingness to entertain further easing. Another neutral member, Mr. Nowotny, continues to ratchet down market expectations as being too aggressive, in order to avoid further disappoint like in December.

Over the last four years, Mr. Draghi  has gone from wanting to protect the euro to driving a portfolio rebalance, which has seen a shift to riskier assets (particularly peripheral sovereign debt). The bank has learned from earlier missteps from the two earlier LTROs (2011-2012)  as to the need to incentivize bank lending by providing a wide enough corridor between lending and deposit rates. Reduction in the deposit rate has also met with some success in lifting inflation expectations (albeit  fleeting), while 10.4% (P) January unemployment in the Eurozone continues to be a worry, it is perhaps better addressed with fiscal policy which remains contractionary.

Source: Bloomberg, Custom Products

Though the ECB was successful in its defense of the constitutionality of OMT (outright monetary purchases), at the European Court of Justice in Brussels, last June. This ‘whatever it takes’ stance,  which it made provision for in 2012, has yet to be applied. Under the current PSPP (Public Sector Purchase Program) launched March 9 2015,  88% of the €60bn/month bond purchases have been allocated to government bonds and recognized agencies. 92% of these purchases are carried out by national central banks in proportion to their ECB capital keys (share of ECB total capital) with an issuer specific limit of 33%, so that the ECB not give the appearance that it was risking its equity to subsidize weaker states.[2]

There remains continued misgivings from the Bundesbank that the ECB must clearly separate the roles of oversight and policy implementation, before the bank directly purchase members’ sovereign bonds, lest it appear to be directly aiding weaker members.  The Bundesbank is also still insisting on a haircut, if necessary, before any sovereign bonds are actually bought by the central bank directly.

The ECB, under Mr Draghi, has conducted itself in an academic fashion, with a strong focus on influencing expectations through communication. It separates the times for scale, maturity and monetary rates announcements to gauge the market’s reaction to each. It also delineates the clear guidance from announced scale. In this way, the ECB has been able to measure the market’s reaction to all aspects of its quantitative easing[3]  Still Mr. Draghi has always insisted that all he needs is a simple majority to carry the day, and given recent votes, this is fortunate. The ECB also does not disclose dissenting votes in final decisions, ostensibly to avoid political pressure and maintain the operational independence of its members.[4] Though one cannot help but get the impression all votes don’t necessarily carry the same weight.

Source: Bloomberg, Custom Products

The ECB’s quantitative easing is already far in excess of any reasonable level deemed necessary to ensure discipline in the overnight market or maintain the portfolio rebalance.[5] However, Mr. Draghi conceded in a December 2015 speech in New York that QE would likely have to exceed €1.46trn thus far if 1.8-2% inflation target was to be achieved.[6] As a minimum, the ECB balance sheet is likely to rise to around €3.74trn by time QE has ended in March 2017.

Source: ECB

Whereas the Fed has been the most aggressive in lowering real policy rates (policy rate adjusted for CPI) since the onset of the GFC (global financial crisis), the ECB now seems poised to retake that lead role. While we expect the Bank to emphasize the abundance of policy tools and sources of liquidity in March, the ECB’s main tool will likely be a further cut to its deposit rate to -50bps. This everyone, should recognize, will simply bring about a further succession of quid-pro-quo cuts from Denmark, Sweden, Switzerland and Japan (and possibly China), so that we could be back in the same place in June that we started out at the beginning on the year.


Source: Custom Products

[1] The role of crude oil prices should not be exaggerated for the EU where the correlation is 0.15 ((t-statistic 2.5) while the US correlation is .29 (t-statistic 5.2).

[2] Benoit Couere, ECB Board Member March 10, 2015 (clearly stated that purchases made by national central banks will not be subject to loss sharing).

[3] Even Mr. Draghi’s predecessor, Jean-Claude Trichet often had the ECB plant rumours in the market that it was buying certain sovereigns by asking for quotes in the short end of the yield curve for Portuguese and Irish bonds in March 2011, when later disclosure revealed that the ECB holdings had actually declined. But the impact on yields was clear. (Depooter, Michiel)

[4] Camila Villard Duran, The Framework for the Social Accountability of Central Banks: The Growing Relevance of the Soft Law in Central Banking, European Journal of Legal Studies, Issue 19

[5] The Bank’s own calculation and our calculation confirm that no more than €300bn is needed to keep Eonia and Euribor rates within 10bps of the deposit rate.

[6] Bloomberg 1.4.16

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