Handicapping the ECB Meeting

The ECB meets tomorrow.  The combination of soft inflation data and Draghi's speech at Jackson Hole has raised expectations for a policy response. 

Many observers have played up the risks of an asset-backed securities (ABS) purchase scheme for which Draghi said preparations are moving forward quickly.  We are more skeptical that the ECB is prepared for this.  There are many moving parts, and not all of them are controlled by the ECB.  Moreover, the issuance of ABS varies greatly through the eurozone, though if the ECB did announce a purchase plan, we could envision banks manufacturing more.  

Rather than an ABS purchase program or an outright QE, we expect more modest measures by the ECB.  We think a 10 bp rate cut to bring the repo rate to 5 bp is likely.  The deposit rate, which is already set at minus 10 bp could be cut further, and the top of the corridor, the 40 bp lending rate could also be shaved.  

Recall that in June in response to the last rate cut, including the negative deposit rate, the euro initially sold off and then rallied to a two-week high.  There was marginal follow through buying the following day, but then the euro slipped lower.  Still, it did not take out the low set initially on the ECB announcement until late July.  

ECB officials seem focused on the Targeted Long Term Repo Operation (TLTRO)  that will be launched toward the middle of this month.  Some observers share our concern that for various reasons the participation may not be as strong as hoped.  The purpose of the TLTRO is to boost private sector lending, and demand is not particularly strong.  Banks are still paying down the LTRO borrowings.  The carry opportunity is not as great.  There are more reporting requirements.  

The ECB may announce more details of what it has called "modalities" or rules of engagement for the TLTROs.  Some small banks, which do not have access to the ECB's facilities, could participate in the TLTRO through a larger bank, for example.  Although the ECB has indicated this, few have focused on the implication.    Since the cost of TLTRO funds is 10 bp above the repo rate, a repo rate cut on the eve of the TLTRO may also help encourage stronger participation.  

The purpose of the TLTRO funds are to facilitate lending to the private sector and not buying sovereign bonds (carry trade), there are not penalties for using the funds for precisely that.  Our understanding is that if a bank's net lending is below the benchmark as of April 2016, the bank will simply have to repay the TLTRO funds in September 2016 instead of September 2018.  

That is to say; banks will get to have two-years of low cost funding regardless of the evolution of their loan portfolio.  On the assumption that banks will be reluctant to take on fresh maturity mismatches, we suspect that the prospect for a repo rate tomorrow and TLTRO borrowings has been a key factor behind the rally short-end of the euro area coupon curves.  The two-year yield in Germany and the Netherlands are negative.  France also flirted with negative territory in recent days. 

Given the rally rally in European bonds, the carry trade is not as attractive as it may have been previously.  However, the cost of the funds is still cheap and, if we are right about a repo rate cut, practically for free (5 bp annualized).  This is, of course, cheaper than any other funds that banks can source.  This is doubly true for smaller and weaker banks. 

What about a full fledged QE program from the ECB?  With the OMT issue still before the European Court of Justice, we do not think there is a critical mass necessary to support the effort.  Moreover, given the euro's decline, about 3% against the dollar since the negative deposit rate was introduced, and a little more than trade weighted basis over the past six months, which is tantamount to some easing of monetary conditions, we suspect there is a reasonably good chance that inflation bottoms in the September-October period.   This may be reflected in the new staff forecasts that will be published tomorrow (and won't be updated until December. 

On the other hand, if inflation does continue to fall and deflation looms, we can envision a scenario for QE.  In order to win the acceptance by Germany and other creditor members, a European-style deal would have to be arranged.  Consider that Italy's President Napolitano wants to step down.  He was persuaded to stay in office longer than he intended.  He turns 90 in the middle of next year, and reports make it clear that he would like to retire before then.

Draghi may get German support for QE if Germany could oversee its implementation.  And recall that with Lithuania joining EMU, a new voting regime at the ECB will be instituted in January 2015.  Not only are the number of policy meetings reduced, but also, not all members, including Germany will vote at each meeting.  This is ruffling more than a few feathers in Germany.  

The proverbial circle can be squared if Draghi steps down as ECB President and takes the high profile post of Italy's president.  Germany's Weidmann is the obvious choice as his successor.  After Trichet, it was supposed to go to the Bundesbank's Weber, who resigned over the ECB's SMP scheme in which sovereign bonds were purchased (and turned out to be quite a profitable investment).  

Some observers have stressed the poor economic performance as a reason for more aggressive ECB action.  We disagree. While we recognize the weakness of the region's economy, we do not think European central banks generally see monetary policy as the instrument to address it.  At Jackson Hole, Draghi called for fiscal flexibility.  This apparently, according to some press accounts, raised the ire of senior German officials.  The German concern is not only over the well-worn moral hazard arguments,  it is about debt in the first place and the rejection of Keynesian demand management.  We have suggested it is very revealing that in German, the word for debt and guilt is the same.  

Structural reforms and the promotion of risk-taking and profit-seeking behavior over the traditional rent-seeking is  necessary.  This does not necessarily mean embracing neo-liberalism.   Germany instituted key reforms several years after the Berlin Wall fell, for example.  Spain appears to be engaging in a similar effort now. 

In fairness, the EU has shown willingness to explore the fiscal flexibility that is embedded in the Stability and Growth Pact.  Has not France, Italy, Spain and others been given more time to reach the 3% deficit target?  Perhaps Draghi's comments were not so much about the debtor countries, but the surplus countries, like Germany.  With the German economy slowing, is there really a compelling reason for it to strive for a budget surplus? 

We also take exception with arguments that contend that the problem in Europe is the lack of private investment.  We think the problem is one of aggregate demand.    The large trade surplus shows that the EMU is producing more goods than it consumes.  Moreover, capacity is under-utilized.    I cannot think of a major country that has had an economic recovery that was led by investment for at least several decades.  Public investment in a different story.  Here it does not appear that all of the funds, including EU funds, that are for infra-structure spending have been used.  European countries are their own worse enemies in this context. 

European officials pride themselves on the rule-based approaches, but the rules are respected often only in the breach.  One area of public investment that euro area countries consistently miss is their pledge to spend 2% of GDP on defense.  Greece is one of the only EMU members that does, and it is probably among the least able to do so (though it buys its weapons primarily from Germany and France, which participate in lending it funds).  In light of the events in Ukraine, and on the eve of the NATO meeting, an increase in defense spending may turn out to be a more viable path.  To be sure, this is not to advocate military Keynesianism, just merely to recognize that it is an area that may be explored on political, economic and ideological grounds. 

The euro has fallen for seven consecutive weeks coming into this week.  The gross speculative short euro position in the futures market is within a stone's throw of the record set just before Draghi uttered his famous pledge in July 2012.  While we expected the interest rate and growth trajectory to sustain the downtrend in the euro, we are concerned about the risks of either disappointment with the ECB or "sell the rumor, buy the fact" type of activity.  Medium term investors should be prepared for the a counter-trend move, which should seen as a better opportunity to get with the trend by reducing euro exposure directly or through hedges.