Great expectations ahead of ECB meeting


Markets primed for ECB announcement of big and bold Quantitative Easing programme.

Markets primed for ECB announcement of big and bold Quantitative Easing programme

• Faltering activity and deflation risks warrant aggressive action

• Big boost to ECB balance sheet expected. Will we be disappointed?

• Many constraints on Draghi’s room to manoeuvre

• Absence of risk sharing could be a major problem

• Continuing fragmentation of single currency area could be a key focus

• Central Bank’s existing holdings of Irish Government debt might constrain bond purchases here

Markets Expect Mr Draghi To Launch The ‘Big Bazooka’

Market expectations are running very high ahead of Thursday’s policy meeting of the ECB’s Governing council. In part, this reflects the tone of recent comments by senior ECB officials that suggest a significant policy initiative will be launched this week. The sense that something momentous will be announced has also been heightened by several recent and surprising developments such as the Swiss National Bank’s decision to abandon its currency ceiling against the Euro.

We emphasise the scale of expectations from the outset because, on many occasions in the past, ECB policy pronouncements have significantly disappointed markets. There can be little doubt that Mr Draghi and his colleagues are acutely aware of significant risks in this regard. However, whether he can exceed fairly lofty expectations is unclear.  If he fails, the reaction could be quite extreme.

Trading sentiment looks to be particularly nervous at present and probably too dependent on a continuing stream of good news from central banks, Thursday has the potential to be a very important day for markets as well as the broader economic outlook for the Euro area.

With policy interest rates effectively at zero—the ECB’S deposit rate has been negative since the 11the of June 2014— any action the ECB can take in response to a weakening outlook for activity and an increasing (if still limited) possibility of prolonged deflation will have to break new ground. In November, ECB president Mario Draghi, indicated that he would seek to boost the ECB’s balance sheet in an effort to revitalise a faltering Euro area economy.

As diagram 1 below indicates, a shrinking ECB balance sheet through the past two years has contrasted with significant increases in the balance sheets of the US Federal Reserve and the Bank of England. This period has also coincided with a marked divergence between solid economic growth and low but still healthy inflation readings in the US and UK economies and persistently disappointing activity and inflation readings in the single currency area.

Measures already introduced by the ECB through the second half of 2014 are falling considerably short of the amounts needed to ensure the ‘intended’ return of the ECB’s balance sheet to its early 2012 levels. Up to this point, the covered bond purchases programme has amounted to €31.3bn after three months of operation while the asset backed securities programme amounted to just €1.8bn. With significant repayments of maturing long term refinancing operations likely to reduce the balance sheet at the end of January and February, the intended €3tn balance sheet size looks a very remote prospect in the absence of quite aggressive and early ECB action.

Against this background, we share the market’s conviction that that the ECB will take a major step on Thursday by announcing an intention to purchase sovereign debt as the centrepiece of a Quantitative Easing programme. As such,  the ECB is about to follow in the footsteps of  the Bank of Japan, US Federal Reserve and Bank of England’s footsteps albeit it with a considerable and not un-important time-lag. However, the ethos of the ECB and the disparate nature of the countries that comprise the single currency area make this an altogether more momentous decision for the ECB than for most other central banks. In turn, this means there is considerable uncertainty about the precise form that QE ECB-style will take and by extension whether these measures will make a marked difference to Euro area economic prospects.

Why Is The Market Looking At €500 Billion Or More?

Market consensus expects at least a €500bn sovereign bond buying programme and this figure has been moving gradually higher through recent days. As a result, anything short of €600-700bn may risk disappointing sentiment. Whatever measures are announced must be seen as more than adequate to drive the ECB’s balance sheet to or above €3 trillion. More generally, there must be some sense that this action will make a meaningful contribution to moving activity and inflation in the Euro area onto a healthier trajectory.

The potential contribution QE policy can make through altering investors’ portfolios, influencing exchange rates and more nebulous effects on sentiment is a very contentious issue at a theoretical and empirical level within economics. Even if we set aside significant debate as to whether and how QE –type policies can exert much influence beyond financial asset prices, calibrating decisions of this sort to current conditions in the Euro area is an almost impossible task.

Estimating with any great degree of precision how an unprecedented policy change of this type would affect an economy that is severely weakened by the recent crisis requires a wide range of heroic assumptions. Our best guess is that a bond purchase programme in the €500-600bn range may struggle to significantly alter the trajectory of inflation in the euro area through the next year or two.

One important pointer in regard to the anticipated impact of an ECB QE programme is provided by newspaper reports last year that cited unpublished ECB research in this area.  These suggested that a €1bn asset purchase programme undertaken for a year would boost Euro area inflation by between 0.2 and 0.8 percentage points. If we take the mid-point of this range as a very rough guide to the likely impact of such a programme and apply it to the ECB’s December projection of an inflation rate of 1.3% for 2016, this argues that in very broad terms a programme of at least €1,000 bn would probably be required to push inflation close to the ECB’s goal of below but close to 2%. Our sense is that this underlies Mr Draghi’s repeated intention to boost the ECB balance sheet to around €3,000bn and our judgement is that the vast bulk of the required net increase of around €800 bn will have to be in the form of sovereign bond purchases. 

What Form Will The Programme Take?

The ECB may not set out the  exact size of the sovereign bond purchase programme they envisage undertaking but they will likely emphasise the intention that it will be adequate to reach Great Expectations Ahead Of ECB Meeting On Thursday21 January 2015 5 their ‘ intended’ level of a €3,000bn balance sheet and this may prompt Mr Draghi to provide some ‘ball-park ‘ guidance. A failure to communicate any indication in relation to the likely size of the programme would likely feed market misgivings about either the determination or the capacity of the ECB  to achieve either its stated balance sheet goal and, by extension, its inflation mandate. Last week’s published opinion of the European Court of Justice’s Advocate General in respect of the legality of OMT’s noted that the ECB must ensure that any such measures it introduces be ‘proportionate’ to the circumstances they address. In this light, we think the ECB may be inclined to give some guidance in relation to QE even if it equally strives not to be pinned down on the precise implementation of the programme.

We think the implementation of the programme will be structured it like the existing Covered bond and asset backed security programmes. Both programmes last until the end of 2016, without pre-set absolute amounts. Such “open-ended commitment” gives the ECB keeps flexibility to alter the size of its weekly/monthly purchases in response to developments in the economy and liquidity provision from other current policy measures.

The QE-programme is expected to include all sovereign bonds with investment grade rating by at least one rating agency. Lower rated bonds could also be bought if the sovereign falls under EU assistance/ oversight programmes. Mindful of this weekend’s Greek election and how that could affect the implementation of this programme as well as the broader outlook for the Euro area it will be surprising if Thursday’s announcement doesn’t build in significant wriggle room in this regard. However, the ECB has also to be very careful that the manner in which the programme is announced does not in itself have some adverse influence on the outcome of that election.

The amount of bonds bought per country is expected to be broadly in line with the ECB’s capital key set out in table 2 below. These percentages are derived from the shares of each country’s GDP and population as a share of the Euro area total.

A couple of important exclusions are likely to apply. Sovereign debt with negative yields which amounts to around 30% of outstanding bonds might be excluded as such yields could raise awkward questions as to whether this might imply direct monetary financing of Governments which is prohibited under the EU treaty.  For the same reason, the ECB will not buy sovereign debt at primary auctions but only on the secondary market at market-determined prices.  Similar concerns will also likely prompt clear limits on the amount that a national central bank can buy of that country›s outstanding debt. Because of the need to prompt significant and lasting changes in investor portfolios, we expect the QE-programme to cover much longer maturities than previous ECB programmes–possibly up to 30-years.

Risk Sharing Is The Key Concern

The most uncertain and potentially problematic aspect of the ECB’s QE-programme set to be announced on Thursday is whether the Great Expectations Ahead Of ECB Meeting On Thursday21 January 2015 7 resultant bond purchases entail risk sharing across the national central banks of the Eurosystem or stipulates that each national central bank is responsible for any losses made on the bonds issued by their respective Government. Under the first scenario, the ECB buys bonds and distributes any resultant profits or losses across national central banks of the Eurosystem according to their capital key. That’s the way the SMP-programme operated. The second scenario is more in line with the approach adopted in respect of the Emergency Liquidity Assistance (ELA), through which a national central bank provides emergency liquidity to domestic credit institutions. In this instance, each national central bank carries all risks stemming from its purchase of domestic bonds.

This second option is seen as a potentially troublesome compromise that is intended to reduce opposition on the part of some ECB Governing council members to any and all forms of QE programmes. Most recent rumours and media comments suggest that the ECB is moving in this direction.  For example, ECB executive board member Benoit Couere said that: “The discussion is how to design it in a way that works, in a way that makes sense. If this is a discussion about how best to pool sovereign risk in Europe, and how to make the pooling of sovereign risk take a step forward in an environment where the governments themselves have decided not to do it, then this not the right discussion. That discussion doesn’t take place in Frankfurt, it doesn’t take place at the ECB, it takes place in Brussels among democratically-elected governments.”

This approach is likely to be seen as notably less effective than an approach that entails ‘risk-pooling’ for a variety of reasons. First of all, there is fairly heated disagreement as to whether it makes sense to think of Central Banks as vulnerable to losses because of the particular characteristics of these institutions and the form their balance sheets take. However, if Euro area Central Banks signal a concern in this regard, private sector investors, who have a potential to incur real losses, are likely to be more cautious in their behaviour. To the extent that QE is country-focussed rather than Euro area-focussed, this may lead to ‹segregated› effects. In terms of the ‘portfolio’ channel through which QE works, there is significant risk that most of the reallocation occurs within national boundaries (although there could be some aggregate effect as well). More significantly, the ‘announcement’ channel that is also seen as central to QE will emphasise the separate as opposed to the shared within EMU.

In a very basic sense, this second approach serves to highlight the fundamental way that the Euro area falls short of being a functioning economic and monetary union. It emphasises the Great Expectations Ahead Of ECB Meeting On Thursday21 January 2015 8 significant fragmentation of financial markets along national boundaries as investors assess the increased linkage between each country’s fiscal and monetary authorities. It also introduces a range of possible complications. For example, in the case of Ireland, the treatment of the Central Bank’s existing holdings of Government debt stemming from the wind-up of the Irish Bank Resolution Corporation (IBRC) could be a constraining factor on the Irish Central Bank’s scope to purchase Government debt under the new scheme depending on the specific limitations imposed.

In the event of any notable deterioration in market conditions, worries about fiscal-monetary authority linkages would be notably amplified. However, if there were to be extreme circumstances in one country, it is not clear that the second approach provides complete protection for other national central banks. For example, a sovereign default and an associated EMU exit would still result in losses for other national central banks via Target 2 imbalances. So, national central banks would eventually share risks even in the absence of risk-pooling. No matter, how unlikely it may be, such a tail-risk event could become the focus of significant and possibly excessive market attention if this approach is adopted.

Will Mr Draghi Save The World?

In an ideal world, ECB-QE would be unlimited and open-ended. There is a significant risk is that Thursday’s announcement merely serves to emphasise how far from an ideal world we are. As the ECB has repeatedly disappointed in the past and its room for manoeuvre is notably limited by fundamental differences of opinion around the Governing council table, the markets great expectations for tomorrow are something of a concern. Certainly, a programme that is regarded as limited either in terms of its size or the sort of restrictions that apply to its operation could lead to very sharp market reactions.

That said, the ECB must be very aware of the potential consequences of an adverse market reaction and we can’t entirely rule out the possibility of a pleasant surprise. At very least, there is the possibility  that Mr Draghi manages to keep markets travelling hopefully by delaying announcement of some of the important details of the QE programme for another day. However, it seems very unlikely that the 22nd of January will come to be regarded as the day that the problems of the Euro area came to an end.