Before the FOMC, Another Look at the ECB’s Actions

The market's focus has shifted to the two-day FOMC meeting that begins today.  The Federal Reserve should be pleased with recent developments.  Labor market slack continues to be absorbed.  Core inflation measures continue to edge higher.

Market-based measures of inflation expectations have risen, and the 10-year breakeven is a little above levels that prevailed before the December FOMC meeting.  The volatility in the capital markets that characterized the first six weeks of the year has quieted.  Domestic US economic activity has improved, and after a disappointing Q4 15, the economy has returned toward trend growth of around 2% here in Q1 16.

The dollar would typically sell-off in anticipation of QE and then rally on the fact.  However, euro's rally that started in the middle of Draghi's press conference last week was particularly striking and has helped fuel talk of the exhaustion of monetary policy effectiveness.

There were numerous moving parts in the ECB announcement of a flurry of measures.  If the markets were disappointed with the steps announced at the end of last year (10 bp cut in the deposit rate and extension of the asset purchases for another six months to March 2017), by nearly all reckoning the ECB got ahead of the curve of expectations last week.

Many have focused on the 33% increase in asset purchases (to 80 bln euros a month) and the interest rate cuts, with the deposit rate now minus 40 bp, and the lending and refi rate were cut by five bp to 25 bp and zero respectively.  Perhaps because they are more complicated, and the full details are not yet available, but the ECB's innovative measures have not received the attention we think they deserve.

There had been concern that the ECB would exhaust some assets, particularly German assets, that it could buy under the bond purchase program.  The ECB announced that it included senior investment grade debt of non-financial eurozone businesses in its asset purchase program. The full details have not been announced.  For example, the precise definition of "non-financial" must be specified.  What other criteria will be used?  Will there be limits based on the float and daily volume?

The universe of investment-grade corporate bonds in the eurozone is estimated to be around 1.5 trillion euros.  Only about a third of those bonds will meet the ECB's criteria.   Volume in the secondary market is relatively light, and this will also be a consideration for the size of ECB transactions.  Just like banks created product that the ECB would use as collateral or buy as in ABS or covered bonds, businesses that meet the ECB's criteria may increase their bond issuance.  Perhaps some bank loans will be converted to bonds.

France has the largest and most developed corporate bond market in the eurozone.  At an estimated 140 bln euros, it is roughly 40% larger than the German corporate bond market.  Italy and Spain's corporate bond markets are about 60% smaller than Germany.    While French and German corporates appear directly the benefit the most, the knock-on effects may help bank bonds and lower grade corporate paper.

The periphery, especially Italy and Spain will benefit from the new targeted long-term repo operations.  They have been the largest users of the previous program (~97 bln euro for Italian banks under the TLTRO and 74 bln euros for Spanish banks).  The rules are more generous for the second round than the first.  In TLTRO 1.0, the banks could borrow 7% of the outstanding qualified loan book.  Under the new version, banks can borrow 30%.

The cost of the funds is initially tied to the refi rate, which is now set at zero.  However, if a relatively low benchmark is new loans is reached, the cost of the entire funds could fall to the deposit rate (minus 40 bp).  Moreover, there are no requirements to repay the TLTRO 2.0 funds if new lending benchmarks were not met.

This is innovative.  The ECB could pay the banks for lending.  In effect, this could offset the cost of the negative deposit rates.   The ECB would be sharing some of the seigniorage earned by the negative interest rates with the banks who lent.  Also, the TLTRO money is four-year loans.  This extends the unorthodox policies even though the ECB did not extend the asset purchase program.  The TLTRO 2.0 will not expire until into the next ECB President's term.

The TLTRO 2.0 are more generous than the first version and interest rates are lower.  The funds will help meet maturing bank bonds, but it is not obvious that the TLTROs will significantly improve new lending.  The obstacles to stronger lending are not liquidity or interest rates.   It is partly regulatory-inspired and partly investor-driven efforts to strengthen balance sheets, which means slow growth of loan books.  There are also demand constraints as business investment is weak and can be financed through retained earnings.  Household borrowing has improved, but with high unemployment plaguing most EMU members and high economic insecurity, it is not particularly strong.