Crazy market swings greet ECB's new plan .... Smoke and mirrors , or something a bit bolder?

Friday 11th March 2016

  

Crazy market swings greet ECB's new plan .... Smoke and mirrors , or something a bit bolder?

ref :- "ECB cuts rates and boosts QE to ratchet up Eurozone stimulus" , the Financial Times p.1, see also in the FT Analysis, Editorial, Short View and Markets

The answer to the question in the title is definitely "something a bit bolder".... ECB boss Mario Draghi and his colleagues managed to include some surprise elements in a package that will at least go some way to restore Mr Draghi's reputation for decisiveness, one that had been a little tarnished  by December's underwhelming raft of measures. We won't know for some time whether they'll prove effective in boosting growth and inflation, and the market moves in the aftermath of the announcement and Mr Draghi's subsequent Q & A session suggested views being reversed even as he spoke.

Anyway, what's the new deal ?

All three of the ECB's lending rates to be eased, including cuts in the headline deposit rate from minus 0.3% to minus 0.4% (which was expected), and the benchmark refinancing rate from 0.05% to zero (which wasn't).

An expansion in the ECB's bond-purchasing QE programme from 60bn euros per month to 80bn euros (consensus expectation was for 75bn). Importantly, the eligible bonds will now include investment grade corporate debt.

A series of four new Targeted Longer-Term Refinancing Operations, known as TLTROs, that will enable banks to borrow from the ECB at a rate that could fall as low as the discount rate (minus 0.4%) depending on how much they lend to businesses and consumers.

This last measure is the most radical .....  effectively, it amounts to paying banks to lend to the sort of areas that will hopefully promote some much-needed growth  --  which is to say, to businesses and households. Crucially, and rather neatly if we may say so, it also mitigates the detrimental effect that negative rates have on bank profitability, currently a source of much concern. Of course, it's a plan that can only succeed if the banks fulfil their side of the bargain and actually pass on the funds to where they are intended rather than using them for other purposes. This will have to be carefully monitored by the ECB. 

This effort to get stimulus to where it is most needed will be welcomed, and taken with Mr Draghi's post-announcement comments for many the package as a whole signifies something of a change in direction for the ECB. Plainly, Mr Draghi is amongst the growing band of policy makers with increasing doubts about the efficacy of negative rates, and in particular about how low they can go. As he said, you can't keep pushing rates further into negative territory and not expect to see some pretty dire consequences for the banking system. According to Karen Ward at HSBC Investment Bank, the new measures change the emphasis from lowering the exchange rate (an unstated aim) and relying on export demand, to trying to fuel a domestic recovery by nurturing the banks to support credit growth .... and that would seem to sum it up pretty well.

Back to the markets, which were comprehensively whipsawed by events. Initial reaction to the announcement, focusing on what seemed like a package marginally more accommodative than expected, was for the Euro and bond yields to be marked lower. But what Mr Draghi said was always going to be as important as the measures themselves, and the implication that rates may have gone as low as they're going to caused a sharp (and huge) reversal of momentum. For example, Euro / USD touched a low of about 1.0835 after the announcement, only to soar up to above 1.1200 on Mr Draghi's words. Similarly, the yield on the 10yr German Bund traded as low as 0.16% before almost doubling to 0.31%. It has to be said that many of the big boys were sitting on their hands over the period, and the resulting lack of liquidity exaggerated the moves. Seems to us that the big boys were the clever ones on a day that offered a salutary lesson in market dynamics.

There are of course some lingering concerns .... not only will it be crucial to ensure that the funds on offer via the TLTROs end up where they're supposed to but also the move to include corporate bonds in the expanded QE programme , fine in theory, may do little to address the imbalance within the Eurozone. The deep markets for investment grade corporate debt lie largely in the major nations, and not much in the peripheral states who need the most help. So there are of course dissenters. In fact, there were two of them on the ECB's 21-man voting committee, and it was no great surprise to discover that it was the representatives from Germany and the Netherlands confirming their hawkish credentials once more.

Still, if it going too far to say that Mr Draghi has pulled any rabbits from hats, he has undeniably been innovative and justified his assertion that the ECB (and central banks generally) do retain weapons in their armoury even if they don't include lower and lower interest rates. Looking at the ECB's revised and thoroughly downbeat inflation forecasts for the next three years, it would be hard to overstate the size of the problem they face. So there are absolutely no guarantees as to whether the new measures will be successful, but the far-from-unanimous consensus, it seems to us,  is that they've made a decent stab at it.