Following the previously noted fireworks from Kuroda, who in a BBC interview said that there is “no possibility” of helicopter money (which however the WSJ quickly added was based on an interview conducted in mid-June which supposedly means there is possibility now) In under an hour the market will turn its attention to the ECB’s latest statement, where as SocGen’s Anatoli Annenkov writes, it is “time to send another dovish signal.” The main reason for this is that as we explained yesterday, unless the ECB changes the structure of its government bond buying program, it may run out of German bonds to monetize as soon as a few months from today.
Using a UBS analysis, we presented the following matrix of what options Draghi has to remedy this situation.
That sentiment persists today, with most banks and analysts expecting more easing from the ECB today. This morning the consensus sentiment is best summarized by SocGen which writes that “as the dust settles and other central banks prepare for more easing, it is likely that the ECB will need to strengthen its dovish tone further. Two immediate challenges stand out: how to deal with a much reduced universe of bonds following the Brexit referendum, which at current interest rate levels causes problems for individual countries, and what to do with the March 2017 reference as a possible end-date for the APP. On the first issue, we believe there is room to increase the issue share limit already at next week’s meeting, but with increasingly complex implications for the aim to stay clear of a blocking minority in the event of restructuring. On the second issue, there is reason to extend the horizon until September 2017, probably after the summer, while still retaining the ability to start tapering (as we expect as of March next year). Next week’s press conference is also likely to focus on the state of euro area banks. While ducking the issues to the extent possible, President Draghi is unlikely to be able to straighten out all the issues as he did in January, when another ECB request caused widespread concerns over the health of Italian banks.”
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Here is a quick checklist courtesy of Bloomberg of what else to expect:
- Any tweaks to the ECB’s QE program and discussion about next steps are in focus as an increasing number of government bonds trade below the deposit rate.
- Draghi’s press conference at 2:30pm CET will be watched for signals on whether further rate cuts are possible given the impact on banks and insurers
BOND SCARCITY AND THE CAPITAL KEY
- Given the pool of eligible bonds is shrinking, some governing council members favor changing the allocation of bond purchases to be more in line with levels of outstanding debt, a Bloomberg source said at the start of the month
- And the ECB has already been quietly exceeding quotas depending on where bonds are available
- However, most analysts agree that dropping the capital key altogether will be a last resort and the ECB will explore other options first
OTHER TWEAKS
- While it’s probably too soon to abandon the capital key, there’s a possibility the ECB could tweak other aspects of the program as soon as today, including dropping the maturity limits or allowing the NCBs to buy bonds with yields lower than the deposit rate
DEPOSIT RATE
- Given the impact of negative rates on bank profitability, the investment community thinks central banks are approaching the lower bound on rates and will increasingly focus on alternative forms of easing
- In June, Draghi said the governing council sees rates at current or lower levels for an extended time; central bank watchers will be looking for any change in that language
BREXIT
- Draghi reportedly told EU leaders Brexit could reduce euro growth by as much as 0.5% for the next three years and the ECB stepped up cooperation with central banks on FX movements after the vote
- Calm markets, the paucity of data on the economic impact of the vote to leave and the BOE decision to wait and see could see Draghi echoing the MPC’s approach, possibly limiting himself to reiterating that the Euro area’s central bank is monitoring the impact and is ready for all contingencies
CSPP
- More than a quarter of the corporate bonds the ECB has bought so far have negative yields
- ECB has bought low-BBB names such as RWE, Metro, EdP, Renault, as well as credits with sub-IG ratings including Telecom Italia, Lufthansa, showing it isn’t shying away from taking credit risk, BofAML says
- To date, the volume of bond buying has surpassed consensus expectations, but the ECB may explain this away as an attempt to front-load purchases given historically issuance slows over the summer
- At some point the ECB may extend the program by buying bond issued by financials but few expect any detail on that yet given the program only began last month
FISCAL POLICY
- Draghi told EU leaders fiscal policy should shift toward investment after the Brexit vote; has repeatedly said monetary policy can’t do all the heavy lifting and Peter Praet called for a concerted effort in fiscal and structural policy
- With Japan apparently readying to provide more fiscal stimulus and the U.K.’s new PM hinting the country may row back on austerity, Draghi may be pressed on how fiscal policy could be used to bolster the impact of the bank’s easy policy
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And the three residual key issues outstanding: what happens after March 2017, the Italian banks, and rising inflation. Some final thoughts from SocGen
Soon time to tell markets what is going to happen beyond March 2017
As markets will demand some guidance on what can be expected beyond March 2017, we also expect the ECB to prepare to extend the horizon of the asset purchases, probably until September 2017. The ECB may well wait until September to communicate this, when new forecasts are available. Depending on how dovish the ECB would like to sound, it could either:
- Extend the horizon without specific mention as to the volume of monthly purchases;
- Extend the horizon but with specific mention of €80bn per month (as in the past).
As this reference is part of forward guidance, and thus a projection rather than a promise, we don’t see any major problem with pursuing the tapering next year if the economic data support it. Indeed, we maintain our current call that the ECB will start tapering in March 2017, as headline inflation picks up towards the target (and real deflation fears ease), and end it in December 2017.
Italian banks remind us of the risks to financial stability following Brexit
For the ECB to start buying bank debt, equity or foreign assets, we believe it would have to expect a significant recession, with major risks to financial stability from high market volatility. With the OMT now having been cleared by the German Constitutional Court, the ECB will feel reassured that it still has some tools at its disposal in the event of country-specific shocks. While the OMT could be activated if a country requests financial assistance involving the ESM, the ECB will face a bigger challenge if there are bigger contagion effects in the euro area financial system. The upcoming stress tests from the EBA at the end of the month have been widely discussed in the press, and ECB President Draghi is likely to be asked lots of questions at the press conference relating to the state of Italian banks, especially against the background of the recent ECB supervisory request to reduce NPLs in one Italian bank. While Draghi may refer to the separation principle with the SSM and the fact that the ECB is not the resolution authority, he is unlikely to be able to calm fears to the extent he did in January this year, following a similar market scare relating to an ECB information request.
Maintaining a dovish stance as inflation rises is going to be a challenge
While the inflation forecasts for September can be expected to be lowered due to the Brexit vote, there are likely also some upside revisions needed linked to the surprisingly low upward revisions to inflation in June. Despite rising oil prices and the additional policy measures decided in March this year, the ECB in June only revised up inflation this year by 0.1pp, while core inflation in 2018 was revised down. In the Accounts from the June meeting, it is fairly clear that there were some expectations that the ECB action in March, which were still being implemented in June, would have some further impact on inflation, with the Governing Council even stating that there “were also upside risks” to inflation.
We expect it to be increasingly difficult for the ECB to manage expectations downwards in an environment of rising inflation in the second half of this year (see Chart 2). While there is likely to be a focus on still low core inflation and the need to see through the energy-driven rise in headline inflation, the ECB could also be perceived as not believing in its own policy measures if the inflation forecasts are very dovish. Combined with the problem of finding an ever-greater universe of assets to purchase, we believe that the improved inflation situation in 6-9 months time will allow the ECB to finally gradually lift its foot from the gas pedal, and start tapering as of March next year. In order to counter any negative market effects, we also believe it will be possible to launch a new TLTRO 3 at that time, starting in June 2017, thereby keeping the momentum on the balance sheet. In a negative economic outlook scenario, we also believe it would be possible to open up the TLTROs to mortgage loans in order to maintain consumer confidence, as was the case with the Funding for Lending scheme in the UK.
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