Friday, April 11, 2014

ECB Action: Just a Question of Time?

by Marc Chandler

The Managing Director of the IMF and the chief economist are making no bones about it. More action by the ECB is inevitable. It is "just a question of timing," says Lagarde and "sooner was better than later", chimed Blanchard, the chief economist.

The market is less sanguine. A recent Bloomberg poll found only about 2/3 of the economists surveyed expected the ECB to ease policy in June. The remainder appear roughly divided between those expecting a May move and those who do expect it to stand pat.

The Bloomberg survey found more economists expect the ECB to suspended the sterilization of the liquidity generated by the bonds purchased under Trichet's SMP program or a new long-term lending facility than QE or negative rates. A fifth of those survey expect a the end of the liquidity absorption efforts, which actually have been relatively smoothly conducted now for several weeks. Another fifth expect new lending facility. The survey found 16% expect QE and another 16% expect a rate cut.

The euro is firm, having trading above $1.39 briefly today, for the first time since March 19 and the backing up of US rates after the FOMC meeting and Yellen's faux pas of defining "a considerable period". EONIA remains elevated above 20 bp, about twice the year ago level (while effective Fed funds at at 8 bp, half of what they were a year ago). The rise in EONIA comes despite the rise in excess liquidity in the Eurosystem of more than 20 bln euros over the past week.

ECB officials continue to play down the generalized risk of deflation in region and claim that inflation expectations remain anchored. However, the real take away is that the ECB is decidedly split about taking more action. An anticipated bounce in the April CPI, for which a preliminary estimate will be made at the end of the month, is expected to buy time for Draghi to forge a broad agreement. A consensus is sought for such an important decision.

Much of the official talk has focused on quantitative easing and ECB officials, including Draghi have signaled a preference for some private sector assets, which the US and the BOE did not do in their QE exercise. In particular, the officials have been talking more about asset backed securities (ABS). The ECB and BOE published a joint paper today urging regulators to support and promote a revival of the ABS market, which Draghi had called "dead". In particular, they wanted "prudently designed" high quality product.

The point though is that the current ABS market seems too small for any serious QE program. Industry data indicate that total European issuance of securitized assets were about 251 bln euros in 2012 and the equivalent of 1.55 trillion euros in the US. In the first half of last year, Europe generated 83.5 bln of ABS, while the US packaged the equivalent of 880 bln euros.

Some of the European ABS are being used already for collateral for borrowing from the ECB, which means they cannot be included in the universe of securities the ECB could consider buying under QE. All told, the ABS that are eligible as collateral at the ECB have almost been halved from the 2010 peak.

To be sure, there is no shortage of debt and can be used for the creation of asset-backed securities. Total lending in the euro area is estimated at around 17 trillion euros. Earlier on in the crisis, the ECB did buy (~80 bln euros) of covered bonds, which are similar to ABS except that the issuing bank retains the risk on their balance sheets and are more favored by regulators.

Many investors and, perhaps, policy makers well, expect that if the ECB would to adopt QE the euro would decline. While understanding the argument, we are less sanguine.  Our argument is not based first principles and deduced from the idea that QE expands the supply of a currency and therefore, ceteris paribus, the currency should depreciate.    Instead, oour approach is more modest.  It is through induction.   

First, the most aggressive QE presently is the BOJ. Since the yen put in its low against the dollar on January 2, it has appreciated by more than 3.25% even while the BOJ has bought more than $225 bln of assets.  Second, we note that the US dollar, on the Federal Reserve's real broad trade-weighted index,bottomed almost 3 years ago (July 2011).  At the end of last month, it was about 6.5% above that trough.   Third, we recall that the large scale QE by the Swiss National Bank did not prove effective, and officials responded by resorted to imposing a cap on the franc. 

A QE operation, a new lending facility, or a rate cut could also induce more buying of the periphery European bonds as the chase for yield intensifies.  Most of the decline, say in Spanish bonds, for example, can be accounted for by the drop in inflation.  Consider that since October 2012, Spanish harmonized inflation has fallen from 3.5% to -0.2%.  The nominal yield of the 10- year bond yield has fallen from almost 6% to about 3.15%.  There is room for a further decline in real yields just to match what they were a year and a half ago. 

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