Expectations were very high ahead of today’s ECB Governing Council meetin

• No major surprises as details of ‘Outright Monetary Transactions’ are broadly as leaked.
• ECB outlines ‘limitless’ capacity but may be hinting at limited usage.
• Treatment of Ireland and Portugal seems to contradict stated aims of programme.
• ECB downgrades outlook of economic growth but inflation seen higher.
• Interest rates on hold for now but further weakening in activity likely to spur another cut.
• Loosening of collateral eligibility also announced as cover against future problems.

Yet again expectations were very high ahead of today’s ECB Governing Council meeting. Admittedly, the broad parameters of the ECB’s new bond buying programme had been signalled through a number of media leaks in recent days. However, there has been a longstanding tendency for European policymakers to deliver somewhat less than anticipated on this sort of occasion. So, Mr Draghi’s announcement of the details of what are termed ‘the Outright Monetary Transactions (OMTs)’ was keenly awaited.
 

In broad terms the main features of the OMTs are as had been suggested in recent media reports. The tone of Mr Draghi’s comments today seemed to be intended to ease ‘Germanic’ concerns that the ECB would act in a manner that might be at odds with the spirit if not the letter of its mandate. This also reflects a significant effort to appease the single voice on the Governing Council who dissented from today’s decision. So, there was a strong emphasis on the ‘conditionality’ of the new bond purchase programme.
 

At the margin, there were some slightly surprising aspects to Mr Draghi’s comments today that may hint that the new programme will be implemented more sparingly than many in the market might expect. Mr Draghi said the OMTs are designed to be a strong backstop that eliminates ‘tail risk’ in the Euro area. Initial market reaction appears to suggest the ECB has been successful in encouraging confidence in this view. However, Mr Draghi also said OMTs were designed to ‘safeguard an appropriate monetary policy transmission mechanism and the singleness of monetary policy’. The differentiated treatment of Portugal and Ireland seems to run completely contrary to this stated purpose. It appears the OMTs for these countries will only be considered when they really no longer need them—when they are about to exit their EU/IMF programmes. If the idea of the programme is to address ‘fragmented’ conditions, it makes no sense to only implant it when countries have overcome such obstacles and are on the point of restoring access to market funding. This approach seems difficult to understand.
 

In contrast to the ‘segmented’ approach there would seem to be a strong rationale for equal treatment for all eligible countries and for early ECB action in regard to Portuguese and Irish debt in order to underscore a commitment to the OMTs. This might be a relatively fruitful approach because the amount of outstanding debt with a current maturity of less than three years in these two countries is relatively small. So, any ECB intervention might be expected to have a substantial effect on the respective market yields. The ‘demonstration effect’ of such purchases might also have a significant impact on market expectations of the possible consequences of potential ECB action in relation to Spain and Italy.

So technically and tactically, ECB action in the Portuguese and Irish markets would seem to have much to commend it. This makes it even more difficult to explain why the ECB would seem to have decided to implement OMTs in a significantly different manner in relation to Portugal and Ireland than appears to be signalled for countries such as Italy and Spain.

Apart from this potentially troublesome aspect, the main elements of the new OMTs announced by Mr Draghi today are along expected lines:

 

1. Bond purchases come with strong and effective conditionality. Bond purchases will only be undertaken when countries have sought EU/IMF assistance and committed to significant adjustment programmes. Even then, ECB bond buying is far from guaranteed; 'the Governing Council will consider outright monetary transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment...'. Many devils could lie in these particular details. As mentioned above, there also seems to be a potentially difficult to justify difference between the treatment of countries in future programmes and those currently in programmes that appear to run contrary to the stated objective of the new ECB measures. These considerations may hint that the scheme may not be quite as ‘user-friendly’ as some in the market anticipate.
2. The ECB will only buy short-dated bonds. Mr Draghi specified that OMTs would encompass the purchase of Government bonds with an outstanding maturity of up to three years. So, it will include bonds that began life as ten year instruments but now have three years or less to maturity. Mr Draghi was very careful not to unsettle markets by avoiding any suggestion that ECB actions might be concentrated towards the very short end (i.e. maturities of one year or less).
3. ECB bond purchases will be sterilised. To prevent any suggestion that the ECB might engage in any form of quantitative easing, Mr Draghi confirmed today that ‘the liquidity created through OMTs’ will be fully sterilised although the precise means through which this will be achieved wasn’t specified. Presumably, the mechanism will be similar to that used in relation to the Securities Markets Programme (whose termination was formally announced today).
4. Concerns about the ‘seniority’ of ECB bond holdings over those of other investors have been addressed. Today’s ECB press release said that the ECB ‘accepts the same ‘pari passu’ treatment as private or other creditors with respect to bonds issued by the Euro area countries and purchased by the Eurosystem through Outright Monetary Transactions in accordance with the terms of such bonds.’
5. There will be no explicit target for yields or spreads. On a number of occasions today Mr Draghi responded to questions on the specific goals of the programme by saying the notion of an appropriate yield is a ‘complex concept’. It seems the ECB will be guided by a desire to ensure that bond markets are not ‘distorted’ based on its own internal assessment as to what this might mean. So, rather than set specific targets for yields or spreads, the ECB will attempt to ensure that markets do not become what it regards as dysfunctional. At this remove, markets may well allow the ECB some leeway on what this might mean in practice. However, a Government considering applying for programme assistance would probably like a little more detail as to when ECB intervention might take place and how far it might go. The Irish Government, in particular, having recently dipped several toes in the water in terms of renewing market access might also like the ECB to be far more specific in this regard.
6. The ECB has no preset limit for the amount of bond purchases. Mr Draghi said on several occasions at today’s press conference that the size would be adequate to achieve its objectives. Again, it will only be when the programme becomes operational that markets will want proof that OMTs are entirely different to the Securities Markets Programme that managed to be controversial and unsuccessful in almost equal measure.

The ECB Also Loosens Collateral Terms

The announcement of the new OMTs was undoubtedly the centrepiece of today’s ECB press conference but Mr Draghi also announced a loosening of the terms of collateral eligibility in the ECB’s credit operations. As Mr Draghi noted, this was intended to ensure ‘the availability of adequate collateral in Eurosystem refinancing operations’. This loosening took two forms. First of all, the ECB decided to suspend credit ratings agency’s minimum thresholds. This change should prevent any substantial deterioration in access to ECB facilities in the event of further downgrades. Second, the ECB decided to re-allow the eligibility of US dollar, sterling and Japanese yen instruments as collateral in Eurosystem operations. Today’s loosening of collateral rules has occurred against a build-up of concern about a scarcity of eligible collateral in some parts of the Euro area. While these measures will be helpful, they are unlikely to have a dramatic impact should market sentiment sour markedly.

ECB Downbeat On Economic Outlook
Mr Draghi also presented new ECB staff projections for economic growth and inflation today. These show a downgrade of growth prospects and an upward revision to the inflation outlook relative to the previous projections released in June. The alteration to the growth forecast for 2012 is broadly as expected (The midpoint of the staff range for GDP is now put at -0.4% against -0.1% in June). This reflects persistent evidence of a weakening in the trajectory of activity as we approach the end of the third quarter. Significantly, recent evidence also points to a notably softer growth outlook for Germany. Of far greater importance, the ECB anticipates only a very limited improvement in European economic conditions through 2013. The midpoint for GDP growth for next year is now put at 0.3% compared to 1.0% in June.
With oil prices higher in Euro terms of late and budget measures likely to boost inflation in a number of countries, it is not too surprising that the ECB’s inflation projections have moved higher. The 2012 inflation projection has been revised up marginally but a more notable change is to 2013, where the midpoint of the projection has been revised up to 1.9% from 1.6%. This is still consistent with the ECB’s policy goal of achieving an inflation rate of below but close to 2% and today’s ECB press statement also emphasises that inflation will ‘remain in line with price stability over the policy-relevant horizon’.

Rate Cut Will Require More Signs Of Weakness
Today’s projections may make some of the more hawkish members of the ECB reluctant to contemplate a further reduction in interest rates. In this context, Mr Draghi said that the question of lower interest rate had been discussed by the Governing Council today but it was felt that it was ‘not the right time’. In addition to today’s higher inflation forecast, this judgement may owe something to an unhelpful rebound in inflation to 2.6% in August from 2.4% in July. Mr Draghi rationalised today’s decision to keep rates unchanged by saying the ECB had already anticipated some deterioration in the economic environment when it cut rates in July. That said, the ECB still sees the risks to its current outlook for growth as weighted to the downside. In addition, its usual listing of two way risks to inflation included reference to a concern that the intensification of financial market tensions ‘has the potential to affect the balance of risks on the downside’. One interpretation of these comments might be that the ECB is holding a further interest rate cut in reserve against the threat of weaker economic data and/or increased market turmoil in the coming months. For this reason, the prospect of another rate cut before end year remains in place.