Update: ECB Announces QE of €60bn/month Through September 2016
ECB leaves interest rates unchanged on all 3 facilities
From the press conference:
- ECB to buy €60bn/month in assets
- ECB agrees to expand asset purchase program
- Purchases will be conducted "until we see a sustained adjustment to path of inflation"
- Purchases to last until September 2016
- Governing council decided purchases of European institution assets will be subject to loss sharing
- Decentralized implementation will be used
- Purchases of securities will be based on NCBs' shares in capital of ECB
- Additional eligibility criteria applied in cases if countries under EU/IMF programs
- Rates on future TLTRO operations will be equal to prevailing rate on main refinancing operation at the time TLTRO is conducted
- Governing Council decided to change pricing of the 6 remaining TLTRO tranches
- Has control on design features if purchases
- Sees continued fall in market-based measures of inflation expectations
- Potential for second round effects on wages from oil has increased and could affect prices negatively
- Inflation dynamics weaker than expected
- ECB will hold 8% of additional asset purchases; 20% of purchases will be subject to loss sharing
- Rest of NCBs' asset purchases will not be subject to loss sharing
- Measures will underpin inflation expectations
- ECB rates have reached lower bound
- See significant differences in monetary policy cycles between major central banks
- Sees sizable increase in ECB's balance sheet
- Eurozone risks on the downside
- Lower oil prices should support households and corporate profitability
- Such inflation rates are unavoidable in the short term given low oil prices
- Annual inflation is expected to remain very low or negative in months ahead
- Risks should have diminished after ECB's decisions today and fall in oil prices
- Crucial structural reforms be implemented swiftly
- All countries should use available scope for growth-friendly fiscal policies
- Will buy government debt up to percentage that will allow proper price formation
- Won't buy more than 25% of each issue
- ECB will be pari passu with investors
- ECB's decisions meant to affect monetary and financial decisions across entire Eurozone
- Risk sharing has nothing to do with singleness of monetary policy
- Wants to mitigate concerns in many Euro countries about potential developments in future from QE
- Senior German conservative lawmaker Michel Bach: ECB is moving further beyond its mandate; ECB's move breaks rules on state financing and is admission that ECB policy has failed to impact real economy
- Issue of potential fiscal transfers is there
- New measures will be effective through several channels
- Believes new measures will raise inflation expectations and address economic situation
- ECB has taken expansionary step today, now up to Governments to implement structural reforms
- Today's meeting was unanimous in stating that asset purchases in a true monetary policy tool
- There was large majority on need to trigger asset purchase plan now
- Volume of QE is in ballpark of getting ECB's balance sheet ti levels of early 2012
- Program designed to avoid any monetary financing
- ECB will purchase securities between 2 to 30 years in maturity
- Most NCBs have adequate buffers in case of negative event
- There has to be a program to buy GGBs; there is also an issuer limit
- Don't have any special rule for Greece
- Will buy bonds with negative yields
- Don't see dramatic increases in leverage or bank credit needed for a bubble
- No bubbles seen so far
- Agrees that some of today's QE measures have already been priced into market
- However, it is the announcement that counts; we are showing credibility with today's actions
A quick take: Slightly more than expected per month, with a slightly shorter duration than expected, amounting to just about €1.1 trillion over 16 months, which is a tad on the low side to the super-aggressive expectations of €1 trillion per year. Furthermore, as expected there will be partial risk-sharing. It is still unclear what are the embedded conditions regarding purchasing Greek or other "risky" bonds.
Mechanics Of ECB's QE
3 days after Mario Draghi made history by launching the ECB's very first QE program, we have seen our fair share of blurry eyed commentators and market participants on the central bank's new measures. On the surface it seems simple, but nothing in monetary finance is ever straight forward. We have to address these misconceptions - not because it does us any good, but it clears some air. This is why Business of Finance even exists.
Let's start with what we know. But before that, the so called QE is fancifully termed the Expanded Asset Purchase Program (EAPP). The EAPP comprises of the ECB's 2 ongoing programs in addition to sovereign securities: Asset-Backed Securities Purchase Program (ABSPP) and Covered Bond Purchase Program (CBPP3).
Funnily, financial media likens this program to "Fiscal Viagra". Fair enough. Now to the business end.
The ECB has committed to €60bn per month in asset purchases through September 2016 at the earliest. The ECB did mention that purchases will continue "until we see a sustained adjustment to path of inflation", meaning the program is actually an open-ended and not closed-ended as many believe. The €60bn per month in purchases are not an additional amount, but rather represents the aggregate amount constituting covered bond and sovereign bond purchases. Many wrongly believe that the €60bn/month forms the additional amount that the ECB will monetize but it isn't; €60bn is the total monthly purchases.
The existing CBPP3 will now be integrated with the ABSPP. On top of this, the ECB will add debt securities of Eurozone central governments, agencies and European institutions. Inflation-linked and floating rate securities issued by central governments, certain agencies established in the Eurozone and certain international or supranational institutions located in the Eurozone will also fall within the ECB's EAPP. In short, the ECB's new EAPP spans the widest spectrum of marketable securities than ever before.
Before the addition of sovereign bonds to its balance sheet, the ECB was only monetizing private sector securities under its Securities Market Program (SMP), Outright Monetary Transaction (OMT) Program, and the current Covered Bond Purchase Program (CBPP3). It then included ABSs in late 2014 to boost its rate of monetization without compromising on price discovery.
The ECB states that it will purchase these securities in the secondary market and not directly from issuers. It does not however state if it will bid for primary issuance through dealers like the Federal Reserve often does. Our guess is that they do, but only to a slight extent if liquidity in the secondary markets becomes too thin.
The reasons for purchasing securities through the secondary market is to for the monetary transmission to work through financial institution rather than directly to central governments and agencies. In so doing, the ECB essentially infuses these private institutions (mostly banks) with Euros, which they can then in turn extend as credit to the real economy. Although we aren't so sure about the last part, this is the ECB's stated intentions. Take it for what it's worth.
There are a lot of details pertaining a program of this scale, but we feel investors should at least take away these key points on top of those already mentioned:
- €60bn/month for 16 months till September 2016 implies €1.1trn to the EAPP at the minimum and can be extended if Governing Council deems fit;
- EAPP consists CBPP3, ABSPP, and the new element of purchasing Eurozone sovereign securities;
- Purchases stemming from the new element will be based on NCBs' share of ECB capital (capital key);
- Purchases stemming from the new element will have a 25% holding limit of each issue;
- Securities purchased must have have a maturity between 2 to 30 years;
- Non CBPP3 and ABSPP securities can be hypothecated (lent out) by the ECB;
- Existing eligibility criteria applies to securities to be purchased;
- There is risk sharing on purchased assets of European institutions (private institutions); 8% of additional asset purchases will be held by ECB, 12% by NCBs - implying 20% of additional asset purchases subject to risk sharing;
- ECB holdings will be marked-to-market and reported on a monthly basis;
- Around 45% of central government securities purchases will be of German and French debt
There are other qualitative attributes to the ECB's EAPP chief of which is the 2% inflation benchmark and the ECB's monitor of market-based inflation expectations. Asset purchases provide monetary stimulus to the economy in a context where key ECB interest rates are at their lower bound, further easing monetary and financial conditions, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately contributes to a return of inflation rates towards 2%.
Securities that the ECB purchases under its EAPP must meet the existing eligible criteria (From the ECB):
They fulfill the collateral eligibility criteria for marketable assets in order to participate in Eurosystem monetary policy operations, as specified in Guideline ECB/2011/14, as amended, subject to the fulfillment of the additional criteria listed in points 2-4 below;
They are issued by an entity established in the euro area classified in one of the following categories: central government, certain agencies established in the euro area or certain international or supranational institutions located in the euro area;
They have a first-best credit assessment from an external credit assessment institution of at least CQS3 for the issuer or the guarantor, provided the guarantee is eligible in accordance with Guideline ECB/2011/14, as amended;
Securities that do not achieve the CQS3 rating will be eligible, as long as the Eurozone’s minimum credit quality threshold is not applied for the purpose of their collateral eligibility. Moreover, during reviews in the context of financial assistance programs for a euro area Member State, eligibility would be suspended and would resume only in the event of a positive outcome of the review;
Additional securities purchased under the expanded asset purchase program that are not covered by the ABSPP or CBPP3 must have a minimum remaining maturity of 2 years and a maximum remaining maturity of 30 years at the time of purchase;
Securities purchased under the expanded asset purchase program that are not covered by the ABSPP or CBPP3 will be subject to an issue limit, an aggregate holding limit and other operational modalities specified, in particular, with the aim of preserving market functioning and allowing the formation of a market price on a given security. Moreover, the limits ensure that the application of collective action clauses for a bondholder decision is not obstructed;
Regarding creditor treatment, the ECB accepts the same (pari passu) treatment as private investors with respect to securities purchased by the ECB, in accordance with the terms of such securities;
Purchases of securities under the expanded asset purchase program that are not covered by the ABSPP or CBPP3 will be allocated across issuers from the various euro area countries on the basis of the ECB’s capital key;
Holdings of securities issued by central governments, certain agencies established in the euro area and certain international or supranational institutions located in the euro area will be valued at amortized cost, in line with Guideline ECB/2010/20 on the legal framework for accounting and financial reporting in the ESCB, as amended;
The eligible counter-parties for purchases shall be those eligible for the Eurozone’s monetary policy instruments, together with any other counter-parties used by the Eurozone for the investment of its euro-denominated portfolios;
Holdings of securities issued by central governments, certain agencies established in the euro area and certain international or supranational institutions located in the euro area purchased under the expanded asset purchase program will be eligible for securities lending;
Transactions in securities purchased under the program will be published in a weekly report which will list holdings at amortized cost by asset type. In addition, for securities purchased under the expanded asset purchase program that are not covered by the ABSPP or CBPP3, a report of the amounts held, valued at amortized cost, and the weighted average remaining maturity by issuer residence will be released on a monthly basis
We hope this section has provided readers with a better idea of what the ECB's EAPP means.
The Twin Sisters
After last week's carnage, the world is just beginning to see the repercussions of the SNB's irresponsible move. We have robustly covered that particular event and although it still weights on the market's and our minds, there is another particular event risk, or risks to be precise, that are nigh. Both happens to culminate in Europe, and within the week. The markets have been sanguine as we start off the week with China just printing a 7.4% growth rate for 2014.
China's 2014 GDP growth of 7.4% marginally beat expectations of 7.3%, but as the mainstream media outlets have framed it, this oasis of economic advancement was the slowest rate of growth in 24 years. What they didn't say is China is still the fasting growing economy of the world; and for it's size, it is something remarkable. We will not opine of the 'raging dragon' in this update but what we will note is China is a true paradox; a 'soft landing' in its monolithic residential and commercial property market, waning industrial production and borderline PMI figures, but relative strength in its overall economic output.
China is, in our eyes, a cesspool of corruption, political bipartisanship, and in a secular transition of its social-economic model; a path all developing economies will face. For the record, Chinese stocks were down massive on Monday (-8% at the lows) - mainly due to the CCP's crackdown on illegal stock brokerage activity where retail 'investors' traded with borrowed money. As if China's lavish social financing doesn't provide consumers with enough credit (albeit low quality junk). Enjoy the faux prosperity while you can.
Moving on, American markets were closed for most the most part on Monday and volatility has been rather subdued as we go to print. Mark our words though, the chop will explode towards Thursday and follow trough the weekend to Monday. "Chop? What chop?" Well, you'll see shortly.
Other than the tempest in the fragile Swiss teapot, last week was filled with messy data releases. US economic and macro data missed across the board; so other than the amazing NFP print and the down tick in the U3 unemployment rate the week earlier, American data was ugly. It seems low oil prices may be 'good' for consumers but not really so for the broader economy. We have spoken a lot about the low oil price syndrome, and its repercussions. We plan to write a dedicated piece to discuss our views on the black gold. Analysts and talking heads have been revising their price forecasts lower almost every week. The latest we read was $25/bbl on WTI by Goldman. Amazing dynamics.
In other news, of good note is the Danish central bank lowering its benchmark interest rate on Monday from -0.05% to -0.2% to preserve the Krone's peg to the Euro; what is an exemplary consequence of the SNB's kamikaze move. The Krone initially traded weaker against the Euro but the knee jerk move was quickly retraced. Confidence in central banking has invariably taken a toll after the Swiss portrayed themselves to be irresponsible. However, as we blatantly espoused, the SNB's move may just have been a precursor to what this edition of the Daily Grail is about.
We now get to the main point of this update.
All Hopes For An ECB QE Of €500bn at the Lowest
For regular readers, this shouldn't come as news. We have been barking like a Pavlovian dog for what seems to be an eternity now. Europe is facing a tidal wave of deflation as was officially confirmed when the EU December CPI printed -0.2%, the first negative annualized decline since 2009. European leaders are now presented with the full frontal of this winter chill; be it from weak energy prices, tepid global demand and weak exports - doesn't matter, deflation is deflation.
We have been warning, since we started going public with our commentary (see here, here, here, here, and here), that the real risk the world (and especially Europe and Japan) faces isn't inflation but deflation. We presented many market-based points of evidence (including inflation breakevens) that suggested that deflation was indeed the juggernaut that will eventually wreck havoc on major developed economies plainly because so many people (including policy makers and government ministers) choose to believe that a deflationary outcome was impossible, and lived a life in denial due to the illusion that quantitative easing had done its job of jacking up prices.
The ECB's Governing Council commenced its conventional 2-day meeting on Wednesday. Consensus has it has it that the ECB will announce its own version quantitative easing (QE). Remember, the ECB has for the last 4 years refrained from embarking on a full scale QE program primarily due to objection from Germany's Bundesbank (national bank of Germany). These German stalwarts and purists of the like have always strongly objected to the outright monetization of sovereign debt because the practice would violate EU constitution - law that does not permit the ECB to be a purchaser and direct holder of these sovereign debt securities.
Ever since the onset of the European Sovereign Debt Crisis, and the coining of the term "financial contagion", the ECB has had to resort to extraordinary solutions to meet this function of monetary policy. Those included the ECB's very own SMP (secondary market program) and OMT (outright monetary transactions) program which failed in their overall effectiveness to suppress borrowing costs in the periphery and stem the contagion that was spreading from the very weak nations like Greece to countries like France, which was part of the Core of the Eurozone.
The SMP and the OMT program were basically mandated to purchase debt securities of banks and other financial institutions in the secondary market, serving as a so called put option beneath the market. Both programs were given relatively high purchase limits but were never used to anywhere close to their full potentials - the OMT program (then dubbed as the ECB's bazooka) was never even in operation and only existed in the minds and never in the arsenal of the bank.
The ECB then tried another approach when it launched its LTRO (long term repurchase operation) in 2 legs, this particular program saw some success in calming anxious markets up was still limited in success because banks that borrowed from that facility would very often re-deposit the Euros into the ECB's overnight deposits. It was actually shocking to the us that the stronger European banks in Germany and France opted borrow from the LTRO facility with a maximum term of 3 years while treating the loans as overnight deposits; earning a negative carry of some 75bps in the process.
The LTRO's limited efficacy in defeating the Chimera within the European continent was solely due to the conundrum of combating insolvency with liquidity infusing policies. This was evident when most banks that took up those 3-year loans ended up prepaying the ECB. In fact, the ECB reported that by the third month, close to half of the initial take-up amount was already repaid, much to the chagrin of the central bank. Banks were overtly signaling to the ECB that they didn't need an additional liquidity window; they wanted a lower cost of borrowing in the Euro interbank market. It was only until mid 2014 that the ECB acted on this message.
The latest round of LTRO, called the TLTRO (targeted long term repurchase operations) saw tepid take up as only €129.84bn in long term loans were allotted to 306 institutions, far less than the expected range. Demand for the ECB's long term loans at preferred rates was dispersed across 51 more institutions than the first auction. This aggregates the total take up amount of €212bn on the central bank's new TLTRO program. This figure is a little under half the ECB's maximum of €400bn for the program. Under LTRO 1 & 2 (precursors to the latest TLTRO), €271bn was allocated to European financial institutions, leaving the current program shy of €59bn from its target (hence the name).
The program that was most efficacious wasn't actually a program. It wasn't even an action by the bank. It turns out, Mario Draghi's (president of the ECB's Governing Council) "whatever it takes" speech in 2012 had the most impact on the financial markets across the entire continent. That epic episode of jawboning, putting even the precious Fed's chair Bernanke to paltry shame, marked the inflection point for many markets. Periphery yields began to fall, spreads began to tighten, and equities began their proverbial surge. Isn't it ironic that least definitive, most ambiguous set or words turned out to the the most effective? It proves that in central banking, one does not need a PhD in Economics and Finance but merely a glib tongue and a lot of reckless tenacity.
Readers might not be aware of the ludicrous skewer effect Draghi's "whatever it takes" speech had on the market. We now have Societe Generale commenting on the just one of the multitude of such examples on the the blazing performance of European equities.
€50bn A Month Till End 2016
The market highly anticipates the ECB to announce a "sovereign QE" program on Thursday. The amount of overall purchases varies from €500bn to €1trn according to market estimates. We have explained the impetuses that would motivate such a scenario, and that the SNB's drastic move last week might have indeed been a precursor to what is to come.
European assets such as European equities together with government bonds have benefited immensely in the run up to the meeting tomorrow. Markets have clearly priced in the event risk of sovereign QE. The Euro has been offered hard in the last 4 weeks mainly on the expectation that the ECB will expand its balance sheet substantially, joining the BoJ to form a coalition of the only 2 central banks of the G7 to be easing monetarily while their peers are contemplating otherwise.
The Stoxx 600 index of companies across the Eurozone rallied 4.8% in the past 4 days, closing at its highest level since January 2008, on optimism that the ECB will step up stimulus measures this Thursday. Economists forecast President Mario Draghi will announce a €550bn in QE. The entire amount of €500-1000bn would probably be spread out across a period of time estimated to span from March 2015 to end 2016. A €50bn/month QE program for 22 months puts the final figure at €1.1trn. We expect the ECB to announce a monthly purchase figure rather than an overall figure, similar to what the Fed did when it launched third round of QE after its maturity extension program ended.
Sovereign QE basically entails purchasing sovereign debt securities of a group of select nations, instead of the current "covered bonds" that the ECB is monetizing. We expect the purchases to be heavily weighted in German Bunds and French OATs (high quality debt mostly from the core countries). It remains a nebulous guess if debt of the periphery nations (Greece, Spain, Portugal, and Italy) will be monetized, and if so to what extent.
Downside Risks Remain
There are always 2 sides to a coin, especially when dealing such opacity. There are traders who are warning that in the unlikely event that the ECB fails to deliver on the long awaited full-scale QE, a great many feel a lot of pain as the massively biased trades that bet on a weak Euro would be unwounded in very short order; a disorderly exit is always painful.
Downside risks clearly remain. There are several scenarios that might unfold.
- An announcement of full-scale QE would be a sigh of relief but depending on the magnitude of purchases, market reactions will vary accordingly
- If there is no onslaught of QE, but increasingly dovish language of further accommodation via even lower interest rates and an expansion of the current covered bond purchase program in scale and spectrum, then the capitulation should not be too acute. Expectations would have to be readjusted quickly, and that will ignite the volatility flares
- An absence of QE but a lowering of interest rates (all or a combination of the 3 rates: main refinancing, emergency window, and o/n deposit) should probably induce some confusion but prevailing trends of a weak Euro and risk appetite souls continue to maintain
- The worst case would be complete inaction by the ECB. This is least likely of the lot, but it is precisely this that presents the short stick the market hopes not to draw on Thursday
Greek Parliamentary Elections On Sunday
Without sounding like a broken record, we will just mention that apart from the ECB event risk on Thursday, people of Greece will take to the polls to vote for their respective parties. Greece is currently without a parliament so this election is important. We have talked about the exact details on how the process of forming a new parliament will be. For those that are interested, we have included an except.
Regardless of the outcome, we have stated that we do not buy the "Grexit" story however scary the talking heads make it sound. We highlighted the main points in one of our previous updates that it would not be in the best intentions for Syriza to orchestrate an exit. Greece and Germany will be the biggest losers if Grexit materializes. We strongly feel that there is just too much at stake, and it would take much more than strong political violation to break this inertia. Greece is nowhere near that stage of destitution.
More updates to come after the ECB announcement tomorrow.
We shall see...