ECB likely to steal the limelight – BBH

Research Team at BBH, suggests that over the last few months, the ECB’s TLTRO II and corporate bond purchase programs have been implemented, but it is too early to evaluate the results. 

Key Quotes

“There does not seem to be a consensus to do more, and, perhaps, the most that can be reasonably expected is to extend the asset purchase program beyond of March 2017.  That is probably the path of least resistance, and if not now, when?  Given the ECB's modus operandi, the next window of opportunity would be with updated staff forecasts in December. 

If the ECB does not announce an extension of its QE, many market participants are likely to be disappointed.  They could express the disappointment by selling bonds, and possibly other risk assets.  However, Draghi could mitigate the backing up of rates by implying that procedurally, the formal decision would be made later, but there was a consensus of dissatisfaction. 

However, the decision to extend the purchases is more complicated that it may appear.  An extension of the program will require a secondary and tertiary decision about the pending shorting, primarily in Germany but experienced on the margins by several other sovereigns as well.  There are several self-imposed rules that could be altered.  The one that has captured the most imaginations is the abandonment of the capital key.  The capital key, in effect, means that ECB buys more bonds are larger countries than smaller countries.

There could be other decision-making rules.  The fanciful one is that rather than buy bonds proportionate to GDP, the ECB could buy bonds proportionate to the size the debt market.  This would favor, for example, Italy over Germany.  It would solve the shortage challenge but spur other issues.  The capital key is an important decision-making principle and many countries,

There are other ways to address the shortage issue.  The most straightforward is to remove the interest rate floor on purchased securities.  Currently, the floor is the deposit rate, minus 40 bp.  There is not a necessary link between the yield the ECB receives for overnight deposits and what the yield it pays when it buys a negative yielding bond.  In these operations it is not borrowing short and lending long, which would make in fact link the two rates. 

There appears to be little appetite to lower the deposit rate further, perhaps in general, but it particularly now.  And it could not be counted on as a reliable way to address the scarcity issue, as yields can be driven lower still.  It could become a little like the dog chasing its tail. The yields fall below the ECB's floor.  The floor is lower.  Yields fall further.  So far, in this experiment, that is what has happened.  Lather, rinse and repeat. 

Some have suggested raising the cap or issuer limit from the current 33%.  While this is a bit arbitrary (what is the difference between say 33% and 45%?), there is an underlying money and risk management issue.  The point is that neither lifting the issuer limit or cutting the deposit rate deeper into negative territory have limited potential to be scaled.”