Yesterday we most likely witnessed Mario Draghi’s last monetary policy package. The European Central’s next meeting on October 24 will be the president’s last, and given the extent of the measures unveiled on Thursday it is looking like a non-event.
The stakes were high as markets had clearly priced in material policy easing from ECB, though there was still considerable uncertainty as to what exactly the mooted package would contain – not least because some dissenting members of the governing council had publicly opposed some of the measures before they were even announced, a point we’ll return to shortly. The specific measures announced were a 10bp cut to the deposit rate to -50bp, a tiering of negative deposit rates for banks to cushion the impact on their margins, terms for a third round of TLTROs and an open-ended quantitative easing program of €20 billion a month.
Markets are still digesting the impact of these measures across different sectors, but a few points have caught our attention.
Firstly, monetary policy in the Eurozone seems to be at, or at least very close to its limits for the time being. This is unquestionably a comprehensive package of monetary policy easing. Markets had already priced in some sort of easing, but we have not seen many market participants saying the package was a disappointment versus expectations. Despite this, the euro is marginally stronger, the front end of the German curve has sold off quite dramatically, while at the same time the curve has bear-flattened and spreads have not moved much. Odd. We believe the reason for this is that it is becoming clearer monetary policy easing at this juncture in the Eurozone comes with some negative consequences. We have discussed some of these previously, in particular tiering for Bund markets and how QE would be necessary to offset some of the negative effects.
Secondly, the message could not have been clearer to Eurozone finance ministers: fiscal easing is needed. This goes hand-in-hand with the first point – monetary policy simply cannot do that much at this stage. This is important, since to us what the ECB is saying is this package will not be enough on its own to significantly lift growth and inflation expectations. If this is true, and we do not have fiscal stimulus or something else that does lift growth and inflation expectations, then the curve will probably flatten. That is what happened in the first few hours of trading after the announcement. An important part of what was announced was tiering for reserves at the ECB. The objective of this is to help banks with their margins, but if at the same time the curve continues to flatten, it might negate some of this intended support for the banking system.
Thirdly, we cannot help but think the ECB governing council is more divided than it has ever been. More than one member of the council stated publicly they do not agree with QE at this point in time. Incoming president Christine Lagarde will have a tough job getting consensus for future policy measures when she takes over in a couple of months’ time, particularly as she is widely regarded as a dove. And while this is not a worry for the time being, we wonder what might happen if and when Lagarde decides to tighten monetary policy in the future. Will these divisions resurface, with peripheral European members voicing public opposition to ECB policy? Not a good look.
In conclusion, we think the ability of the ECB to stimulate the economy via monetary policy easing is exhausted, or very close to it. In order to lift growth expectations, there is little doubt in our minds that fiscal stimulus and structural reforms are needed. The ball then is in the court of Eurozone politicians, which is hardly reassuring. In the meantime, as long as our base case of an economic slowdown but no significant recession plays out, default rates should remain at low levels. That said, we do think exposure to single-B and lower rated high yield names in Europe is risky, since we fail to see how this package will be effective in lifting growth expectations on its own.