Event Risks in the Week Ahead

The key event in the week ahead is the ECB meeting.  The ECB surprised many in early September by cutting key interest rates.  We had anticipated it because although Draghi had indicated their rate policy had been exhausted, he acknowledged there some still scope for technical adjustments.  We had thought it bolstered the chances of a successful TLTRO, as with a five bp repo rate there could be little hope in lower rates later.  

Although many think that there can be no further interest rate cuts, Draghi did point to the possibility of some adjustment in the rate corridor. For example, it is conceivable that the ECB could cut the lending rate, which is the top of the corridor.   Still, it is unreasonable to expect a change in the rate corridor this week.  Instead, the focus is on the "modalities" or terms of the asset-backed purchase facility that Draghi in early September.  

After the low takedown at the initial TLTRO, market participants are anxious for details about the ABS and covered bond purchase plans.  The idea being that the low TLTRO borrowing points to a more aggressive asset purchase program.  The key is boosting the ECB's balance sheet, as Draghi indicated, back to levels in mid-2012, which is about one trillion euros from current levels.  

The problem is the that the ABS market is relatively small.  The outstanding ABS at the end of the 2013 was roughly one trillion euros.  Of this amount, only about half is estimated to be in the market. The other half is being used for collateral for funding at the ECB.   This is an important point about the potential for the ABS purchase program, but also about the ECB's experience in assessing the risk and pricing such securities.  

There are four components to the ABS universe that is relevant here.  The single biggest part by far in the assets back by real estate mortgages.  That is roughly 60% of the ABS market in Europe. The size of the remaining components shrink dramatically.  Traditional ABS, backed by car loans, leases and that sort of activity, is about 15% of the outstanding market.   Another 10% of the market are ABS backed by loans to small businesses.  ABS backed by loans in the form of collateralized debt obligations account for roughly the same amount.  

Of the existing stock of ABS securities, Netherlands accounts for a little more than a quarter.  Italy and Spain together account for about a third, which is evenly divided between the two.  It falls considerably after these three.  Belgium accounts for about 8% and Germany 6%.  Ireland is just shy of 4%, and France's share is a tad lower, just below 3.5%.

There are three elements that investors want to know from Draghi:  the size, components, and duration of the ECB's purchase plan, which will be conducted by an asset management firm. Reuters reported recently that the initial plan for the ABS (and covered bond) purchase program anticipated up 500 bln euros.  This suggests that the TLTROs were anticipated to expand the balance sheet by another 500 bln euros).   The risk is that the ECB does not announce the size of its program. This preserves the most about of flexibility by not doing so.   

By telling the market the components of its ABS purchases, investors can quick estimate the maximum the ECB could purchase of the existing stock, and make judgments accordingly.   There are several other moving parts here.  For example, it is not yet clear what Draghi meant by "simple and transparent" ABS that the ECB would purchase.  The ECB could also lower the rating of ABS that is is willing to accept.  This would boost the securities available, of course, and assist the peripheral banks more.  

Under QE3+, the Federal Reserve told the amount it would buy of long-term securities, but left the duration of the program open-ended.  The ECB could turn this formulation on its head.  It could indicate that it would make monthly ABS purchases for the next two years.  This would encourage banks to "manufacture" the securities the ECB will purchase, the same way they are manufacturing the collateral the ECB was willing to accept.  

If the ECB limits itself to new securities only, the impact will likely be small.  There was an estimated 240 bln euros in ABS issued in 2013 and about 150 bln euros in H1 2014.  Much of this may already sit with the ECB in the form of collateral.  Buying old issuance may not offer a power incentive to increase current and future lending, though it does help banks de-leverage.  

If the ECB wants a large program, it needs to provide banks incentives to create more.  This implies a slow start.  If the ECB wants to start quickly, it may find that its program will be small. It may adopt other technical policies that will help augment the purchase program, including collateral and credit rules.   

While the ECB meeting dominates the agenda, it is, of course, not the only event of the week.  A second highlight is the US jobs data. The market expects a large bounce back after the surprisingly weak August non-farm payroll increase of 142k.  We expect that the US economy loses some momentum seen in the middle two quarter of he year.  Q2 GDP was revised to 4.6% last week and Q3 appears to be tracking something a bit north of 3%.   Expectations will be fine tuned after this week’s personal expenditure, construction spending, and trade balance reports. 

We suspect Q3 is ending on a soft note and that payback will be seen in Q4.  It is difficult to envision US auto sales building on the strong 17.45 mln pace.  That said, GM, Ford and Chrysler likely picked up market share. 

Weekly initial jobless claims bottomed in mid-July, and although they have not deteriorated, the improvement has stalled. Republicans appear to have a strong chance to capture the Senate from the Democrats in November.   This may freeze some private sector decision making in anticipation of better legislative climate, including corporate tax reform. 

The market may get the 215k increase in non-farm payrolls the Bloomberg consensus shows.  However, it may not be in quite the form it would like.  Given historical patterns the August series is likely to be revised higher. 

We do not expect this week’s data in the US, Europe or Japan to influence the outlook for policy.  It would be only mildly encouraging to see, for example, a tick up in the euro area flash September CPI.  It is too early to see expect the impact from the euro’s decline.  The euro area PMIs will be interesting only for mapping relative movement of the core and periphery. 

The UK’s three PMIs are unlikely to alter the view of a BOE rate hike in Q1 15.  The readings may be consistent with a moderation of activity, but they are expected remain at elevated levels. 

Japan’s Tankan survey is expected to show that corporate Japan is a bit less optimistic on balance.  The sales tax increase is have a greater and longer impact than the government had expected, and recently the government has downgraded its assessment.  It is little wonder that businesses do also downgrade their assessment.  We suggest the focus of the policy response will be on a supplemental budget rather than the expanding the BOJ’s asset purchase program.  We anticipate the the yen’s recent sharp decline will boost inflation in the coming period.