ECB rate cut and asset buying programme – analysts’ views

4th September 2014

Expert views on the European Central Bank moves on interest rates and the asset buying programme

Interest cut will have limited impact

Schroders European Economist Azad Zangana, and Fixed Income Fund Manager Chris Ames

The European Central Bank (ECB) has cut interest rates further in an attempt to boost domestic demand and reduce the risk of deflation in the euro area.

The main policy interest rate has been lowered from 0.15% to 0.05%, while the deposit rate, previously lowered to -0.1%, has also been lowered to -0.2%.  In addition, ECB President Mario Draghi announced that the central bank will start to purchase private assets – in particular, asset backed securities (ABS – mainly securitised debt).

More details of purchases including size and scope will be revealed at next month’s ECB press conference. At the meeting in June, the ECB had previously announced that it would investigate the feasibility of buying ABS, and so the follow up and announcement of future purchases are not a surprise.

Draghi cited a combination of the worsening of the inflation outlook, the recent downward movements in all indicators of inflation expectations, poor growth in bank lending, and the weak growth data published over the last month as the key reasons for adding further stimulus.

So far, risk assets have responded positively to the news, with European bourses trading higher, government bonds seeing lower yields, and the euro depreciating. In our view, the cut in interest rates is totally irrelevant. Due to the glut of liquidity in money markets, short-term interest rates have been below the ECB’s main financing rate for some time – meaning that the latest cut will have near zero impact.

Europe’s asset backed security market is small. The ECB is not buying sovereigns

Schroders European Economist Azad Zangana, and Fixed Income Fund Manager Chris Ames

The purchase of ABS is designed to transfer the risk of packaged loans from banks to the ECB, which in theory should free up capital for those banks to increase lending to households and corporates.

Of course, there is no guarantee those banks will choose to lend more, especially as some are under pressure from a regulatory position to boost their core capital holdings. Moreover, according to JP Morgan, the ABS market in Europe is very small. Europe’s ABS market is worth approximately €1.2 trillion, but excluding non-eurozone issue, the market is just €885 billion. However, as most of the existing stock of ABS is being used as collateral to access various ECB repo operations, the actual available stock in the secondary market is just €251 billion – barely worth 2.6% of GDP.

Compared to the size of the Fed’s balance sheet of $4.4 trillion (approximately €5.7 trillion), the ECB’s ABS purchases are unlikely to be large enough to make any real impact on the real economy. From the view of market participants, the ECB is also likely to crowd out long-term buyers of the asset class, which may irreversibly hurt the health of the market in the long-term.

The limitations of the ABS market have naturally pushed investors to conclude that the ECB will eventually be forced to buy other assets, but in particular, sovereign debt, in the same way the Fed and Bank of England were. For now, this is not on the ECB’s agenda, and if the ECB’s staff projections are right in forecasting a recovery in growth and inflation for next year, the ECB may never have to embark down that controversial path.

This marks the beginning of QE and, taken with other measures, will boost the ECB balance sheet by Euro 1 trillion

Martin Harvey, fixed income fund manager at Threadneedle Investments

The recent drop in inflation expectations inspired both a cut in interest rates and a firm commitment to ABS purchases, which alongside the upcoming TLTROs could boost the central bank balance sheet by up to €1trn Euros. There are certainly question marks surrounding the technical difficulties of large-scale asset purchases, which explains the hesitancy in committing to a specific size, but the policy commitment should be big enough to boost confidence in the ECB’s ability to meet its mandate.

This will mark the beginning of Quantitative Easing, albeit without going down the more traditional route of sovereign bond purchases. Institutional hurdles remain to such a policy but it remains in the armoury if the economic situation were to worsen further. For now, this policy should  provide further solace to risk assets and a continuation of the recent ‘hunt-for-yield’ theme in fixed income markets, at least until we find out how quickly the balance sheet expansion occurs.

Currency implications – Euro sinks as ECB does everything it can to prevent deflation

Andy Scott, associate director at foreign currency specialists, HiFX

As inflation among the Eurozone economies continues to fall amid high unemployment, weak demand and German driven austerity, the ECB have been forced to do whatever it takes to prevent deflation. Three months on from its last cut in both the main lending rate and the deposit rate, taking the latter into negative territory for the first ever time, it cut both rates again by 0.1%. It also announced an asset backed security and covered bond purchase scheme to begin from next month, though no amount was outlined. In addition, they reaffirmed that all members are unanimous in their agreement to use all unconventional instruments (meaning quantitative easing) if needed to address risks of an excessively prolonged period of low inflation.

Essentially they are trying to force banks to lend through even cheaper rates on the long-term loans that are available from this month, adding more money into the financial system and charging banks for any excess cash they’re holding that they would otherwise deposit overnight. They incorrectly forecasted the growth and inflation outlook and are now behind the curve and need to catch up quickly. The difficulty is that many of the economies in the Eurozone are seeing minimal growth or are contracting with high levels of unemployment and economic indicators, pointing to a worsening outlook. In such an environment, banks are understandably going to be more cautious when making lending decisions and equally, so too are individuals and businesses about borrowing. This is why Mario Draghi has signalled that monetary policy alone can only go so far to spur growth and prevent disinflation turning into the dreaded deflation.

The ECB also cut its growth forecasts for 2014 from 1% in June to 0.9% and for 2015 from 1.7% to 1.6%. If governments within the single currency bloc are either unwilling or are prevented from supporting their economies through fiscal measures, at least the ECB can say they did all they could to prevent the bloc slipping into a Japan style period of deflation and recession/stagnation.

At the time of writing, the euro was down over 1% against the dollar and the pound had fallen to its lowest level against the U.S. dollar since July 2013. With tensions in the Ukraine and the subsequent sanctions imposed by both sides only just starting to filter through into the economic data, the outlook for the Euro area looks rather gloomy and we would expect the actions of the ECB to continue to weigh on the euro against both currencies. We continue to look for EUR/USD to end the year towards 1.2500 and GBP/EUR towards 1.3000.

 

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