A humble address to the ECB

Key points:

  • US cycle: look in the backyard as well
  • G20 meeting: moving the cursor on trade war
  • European Central Bank: what about buying bank bonds?
  • What the Street is Saying: the limits to ECB action

US cycle: look in the backyard as well

In principle, trade wars should affect US domestic demand via price signals. The tariff hikes would trigger a decrease in households’ purchasing power via a spike in consumer prices unmatched by wage gains, while corporate profits would fall over rising input costs. For now, these effects are muted. Excluding the volatile fuel and food components, total US import prices have actually sharply decelerated, even posting systematically negative yoy change for the last 5 months (-1.5% in May). In other words, the global moderation in inflation currently fuelled by the deterioration in the global cycle is (for now) trumping the impact of the tariff hikes on a subset of Chinese products.

However, investment is already taking a hit. This week’s release of the capital goods orders for May – although decent on a monthly basis – has not broken the decelerating trend which started in late 2017. Interestingly, the current pace is close to where it was in 2012 when the global cycle was hampered by the Euro area’s relapse into recession on the back of the sovereign crisis (Exhibit 1). This should be a reminder that – although a fairly closed economy – the US will not be completely immune to the global cycle. Manufacturing surveys (always the first to pick up weak external demand) such as the Manufacturing ISM have already softened a lot (to its lowest level since November 2016).  While this sector now accounts for less than 12% of US output, it still plays a major role in the gyrations of the US cycle, given its key role in investment and inventory behaviour.

Exhibit 1 : bad news for US investment


Exhibit 2: Watch this space – housing market not spurred by lower mortgage rates

Some purely domestic issues also need attention. We have already drawn attention in Macrocast to the deterioration of the US housing market. This week’s release of new home sales for May confirmed the downward trend (Exhibit 2). In spite of the decline in mortgage rates from the highs of early 2018, combined with a stellar labour market, activity in this sector continues to soften. The fading effect of last year’s fiscal push is leaving a much more balanced picture on the state of the US economy, even when ignoring the impact of the trade war.

G20 meeting: moving the cursor on trade war

It is unclear what the benchmark is to gauge the outcome of the G20. It seems to us the market has given up expecting an actual deal at the meeting between the US and Chinese leaders on Saturday (at least on the US negotiators have been playing expectations down). A non-committal “willingness to continue negotiating” is probably the central scenario at this stage, but the real issue is what the US will do with the escalation of tariffs planned for early July.

On Wednesday Donald Trump stated he might opt for a 10% rise instead of the scheduled 25% on the remaining Chinese products. This is probably to be understood as a way to give himself leeway to apply more pressure on China in future talks without (i) being seen as “capitulating” to his protectionist supporters nor (ii) moving immediately to a level of tariff which could lead to a complete breakdown of the talks with Beijing. While this path might still be considered as “not too bad” by the market, even a smaller than feared further rise in tariffs would probably convince the Fed to ease in July.

ECB: what about buying bank bonds?

The ECB has been talking up its readiness and capacity to provide more stimulus. Still, all the options currently on the table present themselves with technical or political limitations. We depart slightly from our approach so far in Macrocast - offering comments and forecasts – to delve here into policy prescriptions. We think there is a good case to make for the ECB to engage in the purchases of bank bonds.

Our starting point is the possibility of another cut in the deposit rate.  The central bank has been clear any next step on this would come with “mitigation” of the adverse side-effects for banks, which is usually understood as engaging in “tiering”, to be clear: exempting a share of banks’ excess reserves from paying the negative rate. Arguably the new round of Targeted Longer-Term Refinancing Operation (TLTRO) will already offer some relief. Indeed, just like a negative deposit rate is equivalent to forcefully reducing the average return on banks’ assets, a TLTRO is a way to forcefully reduce the average cost of banks’ liabilities. However, the ECB this time chose a fairly low horizon for the TLTRO (2 years) and a less generous interest rate - 10 basis points (bps) above the deposit rate. Moreover, this new round of TLTROs merely allows banks to roll-over the previous round. There is no actual additional stimulus on that side.

In the current version of the ECB’s forward guidance, policy rates would stay at their present level “through the first half of 2020”. We think it is likely the central bank would extend this forward guidance if it were to cut further. In addition, it would probably introduce the notion that rates could go even lower. Finally, the very fact that the ECB would introduce “tiering” – thus making the negative deposit rate more manageable – would in itself be an indication that it intends to keep it below -40bps or take it even lower for an extended period of time likely to exceed the term of the TLTRO. In other words, it is very possible that the next batch of further decline in the average return on assets triggered by another depo cut exceeds any relief brought about by the TLTRO on the liability side.

Tiering would bring relief, but in a very heterogenous way. Two thirds of the excess deposits are in German, French and Dutch banks. Only 10% are in Italy and Spain. For the latter countries, tiering will not provide any significant support to profitability, while the further drop in money market rates will continue to erode their expected margins. This is particularly true for Spanish banks, which tend to hold a lot of liabilities (mortgages in particular) which are indexed on short term market rates (moving in synch with the deposit rate). The benefits for monetary policy transmission would thus be limited. Tiering would simply help banks cope with even more negative rates in countries where credit origination is already comparatively robust (France and the Netherlands) or where it has always remained insensitive to the level of interest rates (Germany), so with little additional effect on aggregate demand there, for very dubious effect on the periphery.

The Euro area is far from certain to win the “race to the bottom” between major central banks. Of course, taking the deposit rate further down could become a more obvious net positive if one forgets about monetary policy transmission through the banking sector and considers its main objective is to depreciate the currency. The idea then is that even the peripheral countries would benefit from improved competitiveness. The problem there is that the ECB is not certain to win that battle. Even with tiering there are technical limits to where the deposit rate could fall (probably at -1% it would become economical for banks to start hoarding banknote rather than pile up deposits at the central bank). On the other side of the pond the Fed has ample capacity to cut. We find it interesting that even though the market is now pricing a depo rate cut by the ECB in September, and expectations of an aggressive 50bp cut by the Fed in July have abated these last few days, the euro is still higher than before Mario Draghi’s latest press conference. And here we don’t even factor in the potential ramifications on the trade conflict between the US and the EU which may re-surface in the autumn.

Buying bank bonds – for the first time - would have a lasting effect on banks’ profitability throughout the Euro area. Even if this new form of credit easing would not necessarily last very long, banks would be incentivised to “lock in” the benefit of the ECB move by ramping up issuance of very low-yielding, long maturity bonds (well beyond the term of the TLTRO). This could be done either in isolation or as an alternative way to offset the impact of another deposit rate cut.

Big bang for your bucks. This investible universe is actually quite small even when compared with the corporate bonds space (Exhibit 3). This is actually a bonus if the objective is less and less to grow the central bank’s balance sheet “no matter what” (which is one characteristic of QE) but rather to trigger a significant drop in funding costs with a minimal financial commitment by the ECB. This would benefit banks in core countries which have to deal with a significant outstanding amount of bonds (Exhibit 4), but Italian banks would also be supported, especially since they are facing by the end of 2020 a wave of debt refinancing (EUR57bn next year after EUR51bn in 2019).

Exhibit 3: Amouts of ECB open market operations and asset purchase programmes

Exhibit 4: Face value by country within EUR Investment Grade senior bank index (in EURbn)

This would allow the ECB to stay clear from purchasing sovereign bonds again (PSPP) for longer. We have already made the point that the situation of Italy is the main hurdle to a resumption of this aspect of quantitative easing (QE). Buying Buoni del Tesoro Poliannuali (BTPs) again while the country is on the brink of another excessive deficit procedure by the European Commission is not very appealing, especially since this would vindicate Matteo Salvini’s position at the end of last year that the ECB should continue with the programme. Symmetrically, not buying BTPs if the macro situation continues to worsen and the political configuration in Rome does not change is not great either. Still, buying bank bonds would to a large extent in our view help protect Italian banks from the usual contagion from a spike in the BTP spreads.

The governance problem has to be weighed against the alternatives. The usual argument against the ECB buying bank bonds is that it could find itself with a conflict of interest since the central bank has also become the supervisor of the Euro area’s biggest banks with some indirect involvement in decision-making in case of banks’ restructuring. This of course is an issue, but in a nutshell, we think these risks are not huge compared with those the central bank is taking by potentially raising further its holdings of sovereign bonds (see our “What the Street is Saying” section below).

To our knowledge buying bank bonds has not (yet) been explicitly discussed by policy-makers. We actually do not think that at this juncture it would rank very high in their preferences. We simply consider that this approach would not be the most problematic on a menu which, unfortunately, is in any case quite unappealing.

What the Street is Saying: Goldman Sachs on QE

The technical and political difficulties facing an extension of the sovereign bond programme are nicely reviewed by Goldman Sachs’ Alain Durre in his European Daily on 27 June. His main point is that the real hurdle is on the capital key – the purchases need to be apportioned across the national sovereign bond markets according to the share of each country in the ECB’s capital. On the issuer and issue cap (the ECB can’t hold more than 25% of a single bond issue and 33% of any issuer’s investible outstanding amount), he thinks there is quite some leeway, with the only legal limit the ECB has explicitly acknowledged being 50% of the investible amount.

Still, we think for the National Central Banks to hold such a fraction of public debt which would make it decisive in any potential sovereign restructuring operation – by pushing it beyond the “blocking minority” threshold stipulated in the Collective Action Clauses of all sovereign bonds issued in the Euro area after 2013 – is a big step to take. A Reuters post this week suggested that the ECB could find some leeway there, by simply considering that as being so “close” to the issuer (the government), National Central Banks should be excluded from the calculation of the thresholds triggering a potential restructuring.

The legal argument is very complex, and there might actually be a conflict of interpretation between the European Court of Justice and the German Constitutional Court on these matters. But beyond the legalese, the political debate on this would be very fierce. And actually we agree with Alain’s ultimate conclusion that at least in first intention the ECB would rather use the wiggle room it still has on the existing programmes (but there is still quite a lot of it of the Corporate bond leg) and consider other options (although he dismisses our “bank bonds” idea) before moving the limits further.

All data sourced by AXA IM as at 21 June 2019

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