ECB Framework: BEEEP

Next week's ECB meeting could very well prove to be among the most important events of the year.  It has taken ECB President Draghi's leadership and increased risk of lowflation if not deflation to forge an apparent consensus at the central bank that more action is needed.

While the "when" has been largely agreed upon (June 5 ECB meeting), the "what" is still an open question.  The signals from policy makers seem to suggest an inclination for several measures that stop short of quantitative easing.

An even bigger unknown is how the markets will respond to the new initiatives, whatever they are.  To help investors try to think through the issues, we created the following framework we have dubbed BEEEP, which is an acronym that focuses on the impact of various actions on the bond market, EONIA, the euro, economy and prices.

In terms of actions, there are three interest rates that could be cut. Market talk suggests there are three technical actions and two different forms of asset purchases that could be unveiled.

Taking our cues from official comments, we place the highest odds on interest rate cuts. Although we have long advocated a cut in the lending rate, which is the top of the ECB's interest rate corridor, we have not seen many others talking about it. This is why we only attribute a moderate likelihood to it. We think it could lower EONIA and reduce its volatility. It currently is set at 75 bp.

We suspect a cut in the refi rate and the deposit rate would have little impact on growth or inflation in the euro area over the next 3-6 months. We recognize that a negative deposit rate cut undermine the euro's exchange rate as asset managers and corporations minimize euro balances. However, we also recognize that a refi and deposit rate cut could spark more demand for bonds, especially peripheral bond markets.

It is controversial, but we are persuaded that there are substantial risks to a negative deposit rate. Not only are we concerned about the impact on money market funds and large corporate and government depositors, but also of the counter-intuitive risk that a negative deposit rate would be contractionary. Negative interest rates would likely hasten the deflation of the ECB's balance sheet. Banks would likely reduce credit to cover charges. There may also be a hoarding of physical bank notes, provided the warehousing costs(vault fee) were not as much as the negative interest rate. 

Measures like extending the full allotment of refinance operations, the suspension of efforts to sterilize the previous bonds purchases under SMP, and even a new LTRO targeted to new lending, are possible.   However, we expect the impact to be minor.  That said, ceasing the sterilization of SMP purchases could help dampen EONIA by boosting the excess liquidity in the Eurosystem. 

There are two different types of asset purchase programs (QE) that have been discussed.  The first involves buying private sector assets.  These could include bank bonds and asset-back-securities.  Prior to the Asset Quality Review and the stress tests, we suspect buying bank bonds would appear to be too much of a conflict of interest, given the ECB's role as a regulator and supervisor.  There are more technical work that needs to be done, it appears before the ECB could buy ABS.  

The second version of QE is for the ECB to buy government bonds.  This could include EFSF, EU, and ESM bonds as well as sovereign bonds.  There are numerous technical and legal issues involved.  We recognize that either variant of QE would be good for bonds.  However, we are less convinced that QE would drive the euro down.  While we understand the theoretical economic arguments about why QE should be currency negative, we are struck by the empirical record.  

Those countries that have adopted QE have not always seen their currencies weaken.  We think of the yen prior to Abenomics, but also the year-to-date performance of the yen, which is the strongest of the major currencies.  We recall the Swiss National Bank was sufficiently dissatisfied with its results that it switched its efforts to simply capping the franc against the euro.  Lastly, we note that the Federal Reserve real broad trade weighted measure of the dollar bottoming in 2011 before QE3+ was even announced.