Markets await more detail on ECB stimulus plan

Eurozone unemployment remains high but has stabilised, and the two-year rally in the debt of struggling eurozone countries – which has to all intents and purposes defied sense and logic, given the weak fundamentals of so-called peripheral nations – has also aided the positive sentiment.

European Union flag flies outside the headquarters of the European Central Bank in Frankfurt

The rally can essentially be traced back to the ‘whatever it takes’ speech by Mario Draghi made back in July 2012. The single currency was under immense pressure at the time as the fears of a eurozone break-up weighed on sentiment. The euro gained some 16% against the dollar over the subsequent 21 months, before topping just shy of the $1.40 mark.

This recovery in the single currency was clearly a double-edged sword. The strength of the currency resulted in a risk of deflation and hampered the economies of export-led countries.

New measures taken over the past few months have reversed much of the euro’s upside momentum and, while this is likely to be beneficial for European companies, the structural reforms within certain eurozone countries have yet to materialise.

Delayed reaction by ECB

Looking back to the earlier part of the year, you have to wonder why it took the European Central Bank so long to act. Despite the fact that the central bank should try and stay ahead of the curve, Mario Draghi was convinced that the ‘moderate recovery of the euro area economy’ was ‘proceeding in line with previous assessment’.

Likewise inflation levels were apparently ‘firmly anchored’ but expected to remain ‘subdued’. Much of the decline in HICP inflation was attributed to energy price developments.

Back then, inflation expectations for the five years from now (as measured by the 5y5y) were above the 2% mandated target. This has changed dramatically – expectations are now that disinflation issues will still be viable.

Eurozone inflation eased back to 0.3% year-on-year in September, from 0.4% the previous month, as expected. The jobless rate in the euro-area held at 11.5% in August. The closer it gets to zero, the harder it will be to reverse.

Consumer spending and deflation

One of the major problems with deflation can be the lack of consumer spending, as the general public expects prices to continue to fall; this in turn can increase the real value of money and the real value of debt. Deflation therefore makes it more difficult for debtors to pay off their debts. For this reason, consumers and firms have to spend a bigger percentage of disposable income on meeting debt repayments. In the grander scheme, the significant sovereign debt loads suffer from debt-deflation dynamics. Lower inflation means that these debt loads do not benefit from erosion over time.

The near-constant rhetoric regarding governments needing to continue with product and labour market reforms also featured quite strongly in early 2014 ECB press conferences. This has not changed. Just last night, Mr Draghi stated that higher investment is needed if inflation is to return to target.

Escalating speculations for more ECB action are apparent, with the euro continuing to slide and weakness in the currency exacerbated by the strength of the dollar.

Today we are likely to see more of the same from Mr Draghi. A dovish tone certainly, but no bazooka will emerge. The ECB is more likely to simply adopt a wait-and-see approach at today’s meeting. Mr Draghi will want to see how recent measures – which include TLTROs, ABS, covered bond purchases, negative deposit rates – pan out.

What is TLTRO?

Targeted Long-Term Repo Operations.

Their main purpose is to stimulate bank lending to non-financial corporations. The operations would offer conditional cheap funding to banks in large sizes, and for maturities of up to four years. Private loan conditions should ease in response, particularly in the euro area periphery, but the impact on area-wide credit is uncertain.

The difference between these and LTRO is that the money is ‘targeted’ and not intended to be spent on sovereign debt or indeed already high-performing asset classes.

The ECB’s balance sheet was around €2 trillion at the end of September, yet there is still a long way to go before it gets back to 2012 levels (roughly €3 trillion euros). The first TLTRO in September was below par, with banks taking up €82.6 billion loans versus €100 billion expected; this amount is clearly very weak compared to the ECB’s goal of maximum €400 billion lending by the second TLTRO scheduled for December. Mr Draghi has stated that this should see more take-up by then, as the ABS and covered bond purchases (private debt buying) will become effective by next month.

Asset-backed securities buying plan

The ECB plans to buy top tranches of certain asset-backed securities. Asset backed securities are defined as financial securities backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities

Today is likely to bring additional information on the quality requirements of the assets accepted by the central bank. Transparency and safety will be paramount – the notion that the ECB would buy riskier assets so long as governments guarantee them has been vetoed already by Germany and France.

The question is whether the ECB will take a discretionary view on the asset-backed securities buying plan. Any indication that it is willing to buy paper with a lower rating is likely to see the euro dive a little lower.

A move back through 1.2570 could see the euro unwind all its ‘whatever it takes’ gains. The chances for disappointment are higher, however, and the bias while above the $1.26 zone is for a bounce back towards 1.2780.

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