What the ECB Did and What it Means

We anticipate that it will take investors some time to digest the new initiatives the ECB announced last week. The ECB will be providing more details as well going forward. Here we will review the actions and discuss the implications of the different measures.

There were five new measures announced:

1. Rate cuts: The entire rate corridor was cut. The marginal lending rate, which is the upper end of the corridor was cut to 40 bp from 75 bp. The refinance rate was cut 10 bp to 15 bp. The deposit rate, which was at zero, was cut to -10 bp. A negative rate has not been adopted by any other major central bank, even the Bank of Japan, despite years of trying to combat deflation.

2. Full allotment extended: The full allotment of refi operations was extended until the end of 2016. In "normal" circumstances, banks are forced to bid for funds. The full allotment provides whatever funds banks want provided they have the collateral.

3. No sterilization of SMP: Under the limited sovereign bond purchases scheme under Trichet (Securities Market Program) the monetary impact was sterilized or offset on a weekly basis. This in effect drained liquidity from the euro system. In recent months, the ECB has frequently failed to fully sterilize the SMP purchases and has decided not even to try going forward. Current SMP holdings are around 168 bln euros. This is equivalent to less than 1.5% of the area's GDP (US and UK QE efforts were proportionately more than ten times larger). Although some observers have called this a mini-QE program, we do not see it that way. The bonds have long been purchased (and incidentally turned out to be quite a good investment) and what is involved now is the liquidity implications. Since the bonds purchased under SMP are maturing, those suggesting it is a mini-QE must then regard the ECB as accepting a passive tapering, which strikes us as unnecessarily confusing the situation.

4. Preparation of an ABS purchase plan: The ECB in conjunction with the BOE want to revive the asset-backed securities market. Some observers and regulators blamed the financial crisis on such securities. The European ABS market is about a quarter of its pre-crisis size. The ECB said it will intensify the preparatory work. Some of this work may be trying to persuade others, such as the Basel Committee on Banking Supervision, that for simple and transparent securities, there is no need for extra (onerous) capital requirements. Coupled with Draghi's warning that interest rates have reached their lower boundary, an ABS purchase plan seems to be the next significant step the ECB will consider.

5. Targeted Long Term Repo Operations: In September and December, European banks will be able to borrow a sum equivalent to 75 of their outstanding loans to the non-financial sector, excluding mortgages, at a fixed rate of the refi rate plus 10 bp. The loans will mature in September 2018. On a quarterly basis, through June 2016, banks will be able to borrow 3x the net new lending that has taken place between April 2014 and the allotment date. These funds must also be paid back by September 2018. Although details were not immediately available, Draghi intimated that through new reporting requirements, banks will be discouraged from using the funds to buy sovereign bonds or lend to sectors that are "already experiencing or just coming out of a bubbly-ish situation."

II

As the ECB's Coeure noted, monetary policy in the euro area is likely to diverge from the US and UK for several years. The risk is that the Bank of England raises rates in Q1 15 while the first Fed hike is seen in the second half of 2015. The ECB's signal suggests no rate hike before 2018.

The cut in the lending and refi and cessation of sterilizing the SMP flows will likely help lower EONIA and minimize the spikes that take place ahead of month and quarter ends. The impact of the next deposit rate is more difficult to determine as it is unprecedented for a large central bank. What we do know of Denmark's experience is not very promising: The impact on the currency was minimal and bank lending did not improve.

In Denmark, the banks largely ate the loss themselves and did not pass it on to retail depositors. The ECB's negative rate applies to more accounts that are maintained at the ECB, including government deposits; that will also be subject to the tax. On one hand, if the cost is of the negative deposit rates are not passed through, bank profitability is likely to fall. On the other hand, profits from the sovereign bond holdings will likely more than compensate in aggregate. We are still concerned about the potential unintended consequences of this unprecedented step.

We have long advocated the reanimation of the European ABS market. The regulatory and technical hurdles are formidable but surmountable. Another obstacle lies with the size of the market. Sales of asset backed securities were estimated at roughly 75 bln euros in 2013, down from 325 bln euros in 2007. Perhaps in anticipation of the ECB initiative, last week saw about 4 bln euros of ABS paper sold, the most for a week in three years. There are several banks that anticipate that the ECB will announce a QE program before the end of the year that will be focused on ABS and, perhaps, jointly issued bonds (e.g., EFSF, ESM, EU). 

We are less convinced that the targeted long-term repo facility (TLTRO) will be very effective in boosting lending to the private sector.  The main obstacles to lending, and why lending has been falling for more than two years is not that the price of money was too high.  Under pressure from regulators and stakeholders, European banks are reducing their balance sheets.  With the regional economy barely growing, the demand for credit also does not appear particularly robust.  

The increased reporting requirements and scrutiny, on top of the Asset Quality Review and stress tests, may also discourage participation.  Ironically, it seems that banks with the balance sheets to participate may not want to, while the banks that want to may not have the balance sheets to participate in a meaningful way.     The facility will not be formally launched until September, and the ECB is going to have plenty of opportunities to clarify and expand its guidance.  For example, it is not yet clear that if a bank does not participate in the September and/or December facility (up to 7% of its private sector, excluding mortgages and financial sector loans) if it can then participate in the other facility (3x new qualified lending).  

While the ECB's new initiatives are noteworthy, we are not convinced that they are a game changer, in terms of euro area inflation (or deflation threat) or what appears to be secular stagnation.  The peripheral European bonds will be supported, and premiums over Germany can fall further in the weeks and months ahead, even though some officials and investors have already expressed concern about the sustainability of such moves.