What to Expect from the ECB

The ECB meets tomorrow.  We do not attribute any significance to the fact that the meeting will be held in Cyprus.  A couple times a year, the ECB meets outside of Frankfurt. 

There are three key elements of tomorrow's meeting, none of which entail a change in policy.   The ECB will provide some more details of its stepped up asset purchases plan that is expected to kick off as early as next week.  The ECB staff will provide new inflation and growth forecasts.  Even if not in Draghi's opening statement, we expect reporters will likely seek some insight into Greek developments.  

There are many technical and logistic challenges to the execution of the ECB's new asset purchase scheme.   The national central banks will be doing the bulk of the purchasing and the risk for most of the purchases will not be pooled.  It is not clear whether the ECB or the national central banks will lend the bonds that are purchased back to the market, or the terms if it does.   It is not yet clear precisely how the bonds will be purchased.  The Federal Reserve did so through reverse auctions, but the Eurosystem appears to be more inclined to go directly to the trading platforms and market makers.  However, the technical and logistic challenges seem to be modest compared to the operational risks.   

The operational risks are two-fold.  First, the amount of sovereign bonds that it plans on buying may exceed net debt issuance for some countries, including Germany.  This will displace existing investors.  We suspect may types of investors will be reluctant to sell their sovereign bonds to the ECB.  Banks, insurers, and pension funds are unlikely to be eager sellers.  They will find it hard to replace the yields and incur tax event.    Moreover, there has been regulatory pressure that has encouraged these investors to buy sovereign bonds. 

In the US experience, foreign banks appeared to have sold more Treasuries and Agencies to the Federal Reserve.   If this experience is repeated, it would imply non-EMU owners could be the featured sellers.  However, ex-EMU ownership appears to be concentrated in the core eurozone bonds (e.g. German and French) rather than the periphery (e.g. Spain, Italy, and Portugal).  One group of investors that we would peg as more likely sellers of EMU bonds to the ECB would be foreign central banks.   With negative yields and a depreciating euro, there already seems to be a move underway to unwind some of the diversification into the single currency. 

A second operational challenge will be in the reporting of the purchases.  If it is done on a weekly basis, like the Securities Market Program (SMP) it may be easier for the market to game, especially if the 60 bln euros a month of purchases is a formal objective. This would allow investors to mark up the price of the bonds they sell to the Eurosystem. 

Look at what is happening with the covered bonds that ECB has been buying since October.  It has accumulated about 51 bln euros or almost an eighth of the entire market, according to some estimates.  Bloomberg data suggests 21 covered bond issues have negative yields that involve more than 21 bln euros of securities.  There are another 10 bln euros of covered bonds that yield less than 2 bp. 

For all practical purposes, eurozone bonds are already at record low yields.  Germany and Finland recently sold 5-year bonds with negative yields.  Austria, which is facing deteriorating financial situation that might snarl even senior creditors, sold a 4-year bond with negative yields.  Ireland's 10-year bond is trading comfortably with a yield below 1%. 

The US experience warns of the risk that "buy the rumor, sell the fact" type of activity.  US yields typically fell in anticipation of the Fed's purchases and would rise as the program got under way.  This would seem especially true if one expects growth and inflation to improve.   Ironically, this seems to be the case prior to the launch of the sovereign bond buying program.  

This will likely be reflected in the ECB staff's new forecasts.    Draghi admitted in December that the staff forecasts did not fully take into account the latest drop in oil prices.   Since December, the price of Brent is little changed net-net.   However, it is still off by about 25% since OPEC's decision in late November not to cut back on output.    The staff may shave its inflation forecasts which were set at 0.7% this year and 1.3% next year. 

On the other hand, the recent string of economic data may spur the staff to lift its forecasts for growth.  It had projected this year's growth to 1.0% and next year at 1.5%.    The new year has begun with favorable upside surprises, including retail sales.  February car registrations, a proxy for purchases, rose the most in more than six months.   January unemployment fell to 11.2%, which while, of course, is still too high, is the lowest rate in 4.5 years. 

While the immediacy of a Grexit has been reduced, as we have noted, more than a third (37%) in a recent Reuters polls still expect Greece to leave the monetary union.  Greece is still at odds with the other EMU members.  What seems like petty tit-for-tat accusations and complaints, Spain (and to a less extent Portugal) have taken over from Germany the immediate flash point for confrontations with Greece. 

Some observers snicker at the idea the Greece rejects the concept of Troika.  However, it was the European Court of Justice and the EC itself which killed the Troika.  There is a clear conflict of interest between the ECB with its supervisory authority and being part of the Troika.  

The deal struck in late February between Greece and its official creditors did not include new funds for Greece.  This is the immediate source of pressure.  Greece owes the IMF about 1.5 bln euros this month, with a small payment (~300 mln euros due at the end of this week).  The ECB caps the amount of T-bills Greek banks can buy to 15 bln euros.  The Greek government was this to be increased.  However, the Greek government, like all governments, have various accounts, and it can simply dip into these and/or delay payments to suppliers (would not be the first government to resort to this).  

The ECB does not appear ready to renew its waiver and accept Greek bonds as collateral.  At next week's Eurogroup meeting, specific, concrete measures will be proposed by Greece Fin Min Varoufakis.  The ECB, like the IMF, wants to see not just the proposals but the implementation.  It wants the proposals to be passed into laws by parliament.  

 While the official creditors are fond of framing the issue in terms of moral hazard, the shoe might fit the other foot as well.  A TV show that aired on Arte for a German and French audience, called "Power without Control: The Troika" called attention to the IMF's decision to lend so much money to Greece in 2010.  The show  accused the IMF of violating its own lending rules under the Exceptional Access Lending facility.  Strauss-Kahn, head of the IMF at the time, and eager to run for the French presidency, reportedly overrode staff objections and agreed to lend Greece 1860% of its quota, which is said to be more than three times the normal maximum for such lending.   

Reports suggest that behind the scenes, the US was critical of the decision.  The IMF's involvement in the aid for eurozone countries was initially controversial within the EMU.  Others outside of Europe also became more critical about the IMF's concentrated risk in Europe.  We continue to suggest that it would be best if the ESM would buy out the IMF and ECB's stake.  Those bonds the ESM would have to issue would be eligible to be purchased by the ECB under its new bond buying program.