FX Daily: The ECB’s big bazooka with a big time delay

6th June 2014

  • Jean Claude Juncker, seen by many as the favourite to be the next EC President, has told G7 leaders he will not step down from his campaign, despite UK concerns. (The Times)
  • Employers in the UK, particularly in London, are finding it increasingly difficult to attract “world class talent” as the soaring cost of housing, both renting and buying. (The Times)
  • Japanese life insurance companies are increasing their foreign currency denominated bond purchases without hedging FX risk. Up until recently, these firms mostly hedged the FX effect via derivatives to prevent losses in the event of yen strength. (Nikkei)
  • Japan’s Abe has instructed his health and welfare minister to prod the Government Pension Investment Fund to announce a portfolio reshuffle in Sept or Oct. Abe would like to see GPIF’s portfolio increase its stock holdings. (Nikkei)
  • The World Bank sees signs of improvement in the Chinese economy, noting that activity, including industrial output, has picked up in recent weeks and is likely to continue for the next two quarters. (MNI Market News)
  • Chinese CPI is expected to see a sharp rebound to well above the 2% in May because of a jump in pork prices while non-food CPI may also see bigger rise on the back of increasing home rental and utility prices. (People’s Daily)
  •  Fed’s Kocherlakota said weak US inflation and employment numbers argue for a long period of low rates even though the Fed’s easy monetary policies argue for a long period of low rates even though the Fed’s easy policies create some risks for the economy. (MNI Market News)
  •  Australia Construction Index rose to 46.7 in May from 45.9.
  • Germany Industrial Production rose 0.2% on the month in April, disappointing expectations for a 0.4% rise and compared to -0.6% previous.
  • German Trade Balance rose to 17.4B in April, from 16.6B, beating estimates of 15.1B. Exports rose a better-than-expected 0.8% on the month while imports increased a mere 0.1%.

In the immediate market test of Draghi’s basket of measures, it looks as though they have failed. The euro did a complete whipsaw yesterday. The euro dropped from a pre-release level of $13608 to a low of $1.3503, before completely reversing and ending up higher. The euro is now consolidating gains around the $1.3650 level. Considering the euro was the explicit target of at least the rate cuts and apparently responsible for 80% of the eurozone’s disinflation problem, this is a concern. Draghi introduced a negative deposit rate, tightened and symmetrised the corridor and threw all the liquidity available at the interbank funding market, everything but QE that is. The reason why the euro rose is the concerns over the transmission of these measures. Yes this is an aggressive and comprehensive set of measures that will add in excess of €565 billion of liquidity to the interbank funding market, lower and reduce the volatility of money market rates.  But while ample supply is all well and good but there is still no demand of funding. Banks are paying back the ECB’s previous LTRO and reducing loan books ahead of the ECB’s Asset Quality Review and increased regulatory scrutiny. The issue for banks is not the cost of funding but the cost of capital and the ECB’s measures do nothing to address this. These measures can only have an impact after the ECB’s AQR and stress tests are complete and the banks have been fixed. Draghi’s measures come with a very big time delay.

The negative deposit rate is mostly symbolic. It a very bold statement by a central bank to actively penalise banks for holding excess reserves and forcing banks to utilise funds whether in the interbank market or by lending to the real economy. It also signals to the world that the Eurozone wants less capital inflows that drive up the exchange rate. While the practical consequences are still unclear, we maintain that a negative deposit rate is a technicality affecting the liquidity management of banks. This will not be passed on to the public in terms of lower savings rates or higher borrowing costs. At the very least, this mainly affects core banks who hold excess reserves at the ECB so it certainly won’t do any damage at the periphery. On the other side of the coin, it is unlikely negative deposit rates will spur these core banks into lending to the periphery, where credit risk remains high in some sectors. As banks search for alternative means of storing excess reserves, it should bring down overall money market rates and yields on core T-bills.

The basket of measures will have their greatest impact on the money market rate. The cuts to the three main rates have resulted in a narrower and symmetric rate corridor which should mean lower volatility and a lower range for the overnight money market rate. The triple attack of stopping the sterilisation of SMP purchases, extending refinancing operations and 4 year TLTRO should bolster excess liquidity in the Eurozone and mean Eonia detaches from the higher refinancing rates and realigns itself to the lower deposit rates. We should now see a refinancing rate of between 5-15 basis points. Wednesday’s EONIA rate dropped to 0.142%.

The next real test for the ECB’s measures will be the take-up of the 4 year TLTRO in September. The question is whether there will be sufficient appetite among banks to engage in these refinancing operations considering demand for credit is low, credit risk is still high and banks are actively cutting their loans books in the face of increased leverage and capital standards. The biggest incentive is that the loan rate will be fixed over its life as well as the extra long 4 year duration. The extension of applications for the Alternative Credit Claims effectively means that some banks will get low long-term funding for already existing loans and potentially also be able to use these same loans as collateral. Considering it’s not until March 2015 when the first applications for new loans begins, this operation is a big bazooka with a long time delay and still question marks over whether banks will take the ECB up on their offer.

We believe the euro will continue to gain in the next few trading sessions as euro short positions are closed out and new money is enticed into the Eurozone by the prospect that this flood of funding will support growth. It’s worth noting that in Eurozone’s bank intermediation system, lending measures arguably matter more than outright asset purchases, though they do not have the same devaluation effect on the currency. In the short-term we see euro-dollar reversing back to the $1.38 level from then on it’s the dollar’s turn to decide the rate’s direction. Is outright QE in the eurozone’s future? We think not though admit that stopping the sterilisation of SMP purchases was a bold move by Draghi to break down the stigma of the first QE. Stopping the sterilisation of SMP purchases is QE, just retroactively. The next step in ECB policy is the launch of ABS purchase, expected over the course of H2. Draghi’s measures yesterday show he is a lot more worried about credit flow to the real economy than deflation.