Draghi’s trap (towards a more national euro-system?)
From: Erwan Mahé
‘Mr Draghi may have laid a fairly sophisticated trap to ensnare his most reticent colleagues.’.
In a happy coincidence, the Fed and BoJ will hold their monetary policy meetings on exactly the same days, the 20th and 21st of September, with enough uncertainty in their decisions to reignite implied volatility in the preceding days! But we should, above all, focus on the ECB meeting, tomorrow, with speculation rampant about the possible changes Mr Draghi may announce in the workings of the ongoing quantitative easing programme (Expanded asset purchase programme, APP). According to the prevailing consensus, given the lack of progress on the inflation front, the still abysmally low inflation expectations, with the 5-year, 5-year still trading at 1.28%, the QE programme should be extended well beyond the announced end-date of March 2017.
This is consistent with the programme’s formulation (emphasis mine): “They are intended to be carried out until the end of March 2017 and in any case until the Governing Council sees a sustained adjustment in the path of inflation that is consistent with its aim of achieving inflation rates below, but close to, 2% over the medium term.” However, given the constraints on the amount of eligible securities, observers are looking for a change in the technical workings of the programme. The Bundesbank in particular may not have enough eligible German sovereign securities, based on the current criteria. A number of measures are being offered to resolve these problems, but the political constraints, notably German reticence toward any measure that even faintly resembles the monetary financing of governments by the central bank or a disguised fiscal union raised doubts about a quick solution to this matter.
Let’s go over these issues and how Mr Draghi may have laid a fairly sophisticated trap to ensnare his most reticent colleagues.
A new cut in the deposit facility rate
Such a rate cut – for example, to -0.50% — would, in theory, enable the Buba to expand its universe of eligible asset purchases, with the 7-year at 0.48% being the first maturity to present a higher rate today. But that improvement would be statistically marginal, because the 8-year maturity is now trading at -0.38%, thereby making it eligible, based on the current floor of -0.40%. Moreover, such a decision could trigger an immediate decline in the yields of said debt, so it wouldin no way reverse the dynamics of the situation because, if the 7-year maturity were to remain below -0.50%, the universe of eligible securities would remain, at best, the same. It could even lead to the further shrinkage of said universe, if the downward movement of long-term rates were to accelerate, with investors betting on further deposit rate cuts. For example, the SNB set its rate at -0.75%, without any noticeable flight to cash.
In addition, the ECB board members seem to have realised just how much these negative deposit facility rates function like a tax on the banking system. If so, they will not want to make the current problems worse, especially with the share prices of German banks (the most cash rich) languishing near their historic lows.
The possibility of buying below the deposit rate
That would resolve the stock of eligible securities problem, but I believe the Germans will view it as too close to monetary financing of governments. I therefore do not believe that approach is likely in the present circumstances. However, it is worth noting that the current limit in no way guarantees that such financing will not occur, since, if the Buba were to buy today, for example, 8-year German bonds at -0.38%, and thus within today’s -0.40% deposit rate floor, how can it be certain that its financing costs will not largely exceed said level during the entire life span of the sovereign security? This is therefore, either potential monetary financing, or one heck of a forward guidance.
A change in the limits by security
The initial limit by security was set in March 2015 at 25% of the size of each issue.This was increased to 33% in September 2015 for securities lacking a collective action clause. The aim of said decisions was to ensure that the ECB did not find itself in the position of a minority blocking creditor and thus in a position of validating a future debt restructuring, which would amount to the implicit monetary financing of the concerned government. It was precisely to skirt any such accusation that the ECB, along with the national central banks and supranational institutions, were excluded from Greece’s debt restructuring, thanks to the magic wand that brought about the change in the ISIN of the securities held just before the restructuring was carried out. However, the APP today accepts a 50% limit on the supranational securities (EFSF, EIB, ESM, etc.), and it would be possible to also use said threshold for the “non-CACs”. However, even if such a decision were to be announced, it would also have only a marginal impact on the Buba’s problem of eligible securities.
Add other assets to the APP
Some people argue for adding other financial assets to the programme in order to make up for the scarcity of eligible sovereign securities. The case of bank debt has been evoked, but that raises a conflict of interest problem with the ECB’s banking sector supervisory duties (Single Supervisory Mechanism, SSM). Since corporate bonds are already massively benefiting from the current programme, with some companies now issuing at negative rates, I think it would be hard to increase this part of the APP. Shares are also being suggested, like the BoJ has done with its QQE. Indeed, the ECB could resort to such measures, once it has exhausted all other options, but I think such an approach is still premature. Some people have even called for buying US treasuries, like China, Switzerland and Saudi Arabia do on a regular basis, but I think that would be too much of a “currency” decision (influencing the currency exchange rate) for it not to trigger an unfavourable reaction from our American trading partners, especially given the current accounts surplus on the eurozone.
A change in the key by country
By increasing the share assigned to the countries with a stock of debt proportionally much higher than their relative share in the ECB’s capital and in the APP as currently conceived, we would significantly increase the universe of eligible securities, since said securities, mainly from the peripheral nations, are trading at higher yields than those of Germany, for example, from 100 bps to 120 bps higher on the 10-year maturities vis-à-vis Spain and Portugal. Said measure would also have the obvious advantage of targeting the eurozone countries most in need of monetary easing, be it in terms of debt-to-GDP, budget deficit or unemployment. The German ECB board members have always publicly opposed such a measure, based on the argument that it amount to a disguised fiscal union, since it would put make the other central banks bear too much peripheral sovereign risk, and undermine the pricing by risk markets on the debt of each national within the eurozone. Mr Draghi could again force the hand of his reticent colleagues by invoking the ECB’s voting rules, which would allow him to override the opposition of some members, including the Germans, but I suspect he has another idea in mind, namely, the trap to which I referred in today’s title.
As noted, the Bundesbank is unlikely to give its go-ahead to any of the aforementioned ideas. This puts it in an uncomfortable position, given its statuary requirement to meet its mandate, which is to bring inflation to its target of slightly less than 2%. It originally opposed the quantitative easing for theoretical reasons, fearing that it would open the way to unbridled money creation, with all the painful memories of hyperinflation that entails. It can no longer oppose the QE on that basis, given no sign of a pick-up in inflation and with inflation expectations stuck at record lows, without being accusing of violating its mandate. It should logically be brought to accept the time extension of the programme and/or quantitative and qualitative enhancements. If it refuses to touch the capital subscription key, it will have to buy longer and longer sovereign debt maturities, in the face of the dwindling stock of eligible securities.
It will thus increasingly flatten the German rate curve, which will further irritate the German commercial and savings banks, insurance firms and pension funds, which have been daily raising the alarm about this problem! In addition, it will significantly increase its duration (mark to market) and carry risk. After all, how can they justify, for example, buying 30-year bunds at 0.40%, when it has no visibility at all on such a time span on the costs of its own resources?
The Bundesbank may thus come around to asking Mr Draghi to change the capital subscription key for its APP purchases to gain access to a stock of eligible securities (and rates). If it wants to skirt the accusation of favouring a fiscal union by proxy, all it has to do is demand that the extra amount of Italian, Spanish and Portuguese sovereign debt securities be acquired by their national central banks themselves, instead of by the Eurosystem, as is already partly the case in the current APP. Such a solution would allow it to show genuine neutrality to its citizens, with its balance sheet not involved in that part of the programme.
That solution would also present the significant advantage of allowing the peripheral states to keep the carry gains made from said transactions, since the net gains earned by the national central banks are returned to their respective national treasuries. Conclusion, the pathway is there, along with the trap. It is just a matter of time before it clamps shut. I think it is a bit early for this sort of decision at tomorrow’s meeting. I am not expecting any sparks on the topic at this point.
PS: All these paragraphs on the ECB’s monetary policy change nothing in my analysis that the problem today is fiscal policy, but since that is today’s topic …
The Macro Geeks’ Corner (MG)
Lars Syll, August 3, 2016
U. Bindseil, European Central Bank, DG‐Market Operations, 31 August 2016
Marvin Goodfriend, Carnegie Mellon University and NBR, August 26, 2016
Ricardo Reis, LSE, August 27, 2016
Laurence Ball, Joseph Gagnon, Patrick Honohan, Signe Krogstrup, 2 September 2016