ECB meeting messaging: Easing into easing, rather than jumping in head first

Invesco's Global Market Strategy Office analyzes what the European Central Bank's latest decision means for European assets - and beyond.

Jul 31, 2019 | Arnab Das, Paul Jackson, Luca Tobagi

  
 

Summary
 

  • The ECB’s dovish rhetoric and decision to explore policy options further, but stay on hold in its 25 July monetary policy meeting fell just short of market hopes. The market initially responded by taking bond yields lower, but then gave back most of its gains. However, assessing the ECB’s next moves – in the context of policy and performance in the US and China in particular – will be crucial for market performance and portfolio rebalancing decisions in coming months.
     
  • In our view, neither the ECB nor eurozone (EZ) governments are ready to act pre-emptively with monetary or fiscal easing, unlike the US which has used fiscal stimulus and is now moving towards monetary easing. This is because domestic demand – especially consumption and services – is holding up well in many EZ economies, supported by relatively tight labour markets and ultra-low interest rates, even as manufacturing and investment suffer from trade and geopolitical frictions.
     
  • We believe this is a risky policy strategy because EZ growth and inflation are already low; many services are linked to industry, investment and exports; and spill-overs from global to domestic performance are, if anything, more common in trade-surplus economies like the EZ, than the US.
     
  • Hence, we expect further ECB easing later this year to try to bolster inflation, consisting of more deeply negative interest rates; renewed quantitative easing (QE) concentrated in EZ government bonds; shifts in the self-imposed constraints on bond-buying; and “tiering” of interest rates to reduce the impact of negative rates on bank profitability and capital.
     
  • But we do not expect a proactive, growth-boosting fiscal stimulus, because Germany and other “Core” EZ creditor countries via the EU wish to impose fiscal rules on members with high public debts or deficits. If / when recession strikes, budget deficits would rise automatically as revenue falls and unemployment benefits rise; only if it gets bad enough would there be sizeable stimulus.
     
  • We would expect this approach to only modestly support EZ growth through a variety of asset price effects but would not expect a rebound in growth – again unlike the US – inflation or inflation expectations. Key aspects of the EZ growth / inflation slowdown, like trade wars, are well beyond the capacity of ECB policy to address. Plus, the risks of a no-deal Brexit are rising, which would be another drag on EZ growth, though more likely to precipitate recession in the UK than the EZ.
     
  • We do not expect much euro weakness because other major central banks are also dovish; the Fed has more policy space to cut rates or buy assets than the ECB; fear of US intervention hangs over the markets (though ruled out by the US administration for the time being and likely to be ineffective if implemented, the threat of verbal/tweeted intervention remains a factor).
     
  • Consequently, we would not expect risky EZ asset classes to significantly outperform other major risky asset classes; we would expect continued capital outflows from Europe to seek out higher returns elsewhere, consistent with the now very large current account surplus. That said, we would expect the supportive effects of renewed ECB easing on inflation and inflation expectations to help support EZ equities and credit asset classes including high yield bonds.
     
  • We find it unlikely the ECB will start to extend beyond fixed income into equities as the Bank of Japan has until and unless there is much greater downward pressure on both growth and inflation, but there would be collateral benefits as the ECB crowds investors out of government bonds into riskier asset classes. 

 

Invesco’s Global Market Strategy Office expects further rate cuts and renewed QE later this year based on the ECB’s 25 July monetary policy meeting, with meaningful financial and market impact



The ECB’s monetary policy messaging: Easy does it…
 

On Thursday 25 July 2019, the European Central Bank Monetary Policy Committee met amid high expectations of a major, early easing in monetary policy. Conjecture abounded about what the ECB would purchase if it were to renew QE, including equities. In the event, the ECB made no actual policy changes, but did amplify its forward guidance, committing that rates will “remain at present or lower levels at least through the first half of 2020”.


The ECB focused on low inflation and clearly signalled that it was likely to cut rates soon, and that it might resume QE soon. The ECB also re-emphasized the symmetry of its inflation targeting approach. At the press conference, however, ECB President Mario Draghi was not as dovish as many market participants had hoped, even though he was clearly concerned that the EZ economic outlook is getting “worse and worse.”
 

Given the headwinds to growth, and especially sliding inflation and inflation expectations, we expect QE to resume this year, possibly as early as Draghi’s last meeting in September, or the first under the new ECB President Christine Lagarde in December, although she may not be ready to announce a new QE program at her first meeting.

 

How much firepower is left? Some – but limited policy space constrains pre-emptive easing
 

We can’t help but doubt how far the ECB can go in being pre-emptive, relative to the Fed, given its more limited firepower – hence the ECB’s reaffirmation of existing signals, rather than their immediate implementation, let alone augmentation. We agree with the consensus that the ECB has much less room than major central banks like the Fed, BoJ or BoE to ease both by cutting rates and buying assets to enlarge its balance sheet, yet we believe there is still meaningful monetary policy space that would have some economic impact, and meaningful financial market impact (to which we will return below).
 

Here is what the QE5 balance sheet looks like with no ECB balance sheet policy change and with resumed QE (assuming e60bn ECB QE per month from October; the Fed stops QT at the same time; the BOJ continues at current rates; and the BOE and SNB do nothing). If the ECB does resume QE in 2019, the aggregate, major central bank balance sheet will exceed its prior peak around mid-2020 (figure 1).
 

Even without purchasing non-traditional assets like equities, a la Japan, the ECB has several self-imposed constraints which it can dilute or do away with, though there are others that it would not be able to do away with. We believe the ECB can remove or at least raise the single-issue or single issuer cap of 33%. That said, the capital key constraint is binding because it reflects the national central banks’ shareholdings in the ECB, as a function of GDP and population weights; staying within these limits would respect the legal prohibition on monetary financing of government deficits or debts. Such purchases, as shown in figure 1, would increase the global base money supply (currency plus bank reserves) to beyond its early-2018 peak during 2020, which could help limit the global slide in inflation.



 

All the monetary constraints on ECB bond purchases are one thing, but another binding issue is the availability of government bonds, especially in Germany, where a so-called debt brake and a constitutional balanced budget amendment restrict the underlying supply of bonds. Given the issuer limits in combination with the capital key, the ECB would be limited in the amount of bonds it can buy and hold, which in turn restricts its ability to increase the amount of money in the financial system.
 

A recession would very likely and probably significantly ease the supply pressures because Germany would very likely allow its budget deficit to widen out during a recession or if there were a steeper downturn due to the trade war, US-China tensions, a no-deal Brexit, or open conflict in the Mid-East.
 

Macro impact of ECB easing: Limited upside to growth and inflation, but better than none
 

The data suggest that QE has not had much direct effect in boosting growth, money or inflation. Put another way, the ECB has had little success in generating loan growth in the economy (figure 2). Any relationship that existed between falling yields and higher loan growth was completely broken during the financial crisis, from which time major central banks have largely been pushing on a piece of string.
 

All this of course raises the question of how effective QE is – a major debate in policy, academia and of course in the markets – indeed, it has emerged since the ECB meeting that some Governing Council members harbour doubts about whether resuming QE is a good policy choice, given its limited effect. Well, we reckon things would be worse without QE. It is clear that the increase in central bank balance sheet size, which reflects the rise in “base money” – bank reserves plus currency in circulation – has helped offset the fall in broader monetary aggregates during the Global Financial Crisis and the EZ sovereign debt crisis and has very likely contributed to overall money growth being higher than it would otherwise have been. Stabilizing or increasing the amount of money in the financial system – hence the name, “quantitative easing” – is a major part of the rationale for QE, not least because the lack of monetary easing contributed significantly to the Great Depression, aka the Great Deflation. The bottom line is that QE might not solve all the ills of the economy – falling short of reflating growth or money and credit, but it has very likely prevented the patient from deteriorating or deflating.
 

Indeed, eurozone loan growth has accelerated recently. Perhaps confidence is returning. Either way, it must be asked whether driving rates even lower is either required or will really generate a major uplift in lending, investment and thereby in growth and inflation or not. The answer would be critical for determining whether the European asset complex remains mired in a value trap or breaks out relative to economically more vibrant economies – the United States in particular (figure 3).
 

The struggles of the banking sector argue against taking rates significantly further into negative territory (figure 3, right-hand chart), which is why the ECB is now talking of cushioning the banks from negative rates through deposit tiering – charging negative rates on only a portion rather than the entire amount of their excess reserves.
 

Deposit tiering would reduce the damage to the banking system, but that would not eliminate all the costs of negative rates. Banks cannot pass negative rates fully through to customers because it would encourage deposit withdrawals; for the same reason, there is an effective lower bound to how deeply negative the ECB can take rates – at some level, it becomes cost effective for savers to hold and store cash rather than pay negative rates to banks, to governments or other borrowers. Similarly, the insurance sector also suffers from low rates. Furthermore, many households save more, not less, when rates go down to compensate for lost interest income; this effect would be aggravated if they were to lose a portion of their capital on a running basis through negative rates.
 

For all these reasons, we believe that even if rates are cut further, there will eventually be additional QE. Even though it might not generate significant growth or attain price stability by itself, it is better than sliding into deflation or depression, which would become a material risk if geopolitical and trade frictions continue to depress investment and to challenge the EZ’s current export-led growth model.



Market implications: Easy come, easy go – ECB easing largely but not completely priced-in
 

To a meaningful extent, the resumption of QE by the ECB has already been priced into various asset classes. However, there is still room for some movement upward. Assets that fall within the perimeter of previous ECB purchase plans (eg govies, non-financial corporate IG paper) should benefit, as should asset classes adjacent to but outside the perimeter of previous asset purchase programs (e.g. non-financial corporate HY paper).



 

In recent years, there has been a relationship between QE5 balance sheet expansion and the performance of global assets (measured by our own global multiasset benchmark). It used to be that QE5 balance sheet led asset performance, but this year asset markets seem to have anticipated more QE. That is, a lot has been priced in already.
 

Nevertheless, the ECB looks set to embark upon both rate cuts and further asset purchases. So, what will it buy? One approach is to take a look at what it has already bought. The chart below shows cumulative net purchases in Eur bn. Public sector bonds account for 82% of net purchases. The obvious reason is size and liquidity; we suspect the size of purchases is related to something like a liquidity adjusted market cap. Also, if and when the ECB’s aim is to protect the integrity of the eurozone, it is likely to be buying public sector bonds (to protect peripherals against speculative attack).
 

Given that QE by all the major central banks and the ECB in particular has already been so extensive, it is hard to find assets offering anything like a decent return by the standards of history, especially in fixed income. Figure 6 places current valuations in the context of their historical ranges and averages over the last 30-40 years (depending on the asset class).
 

Now, it would get really interesting if the ECB were to turn Japanese! Figure 6 shows that equity and real estate yields are more in line with historical norms. If the ECB wants to goose up animal spirits, it could try to wrong-foot all those investors turning their backs on the region’s equities. This could help corporates to raise money more cheaply and may have as much of a chance as any other purchases of reinvigorating the economy.
 

So, accepting that QE has historically been associated with better asset returns (and hoping that it is not already in the price), what should one buy as we contemplate an autumn launch of the next ECB QE package? Though the ECB may buy more publicsector debt than other types of asset, that is only because there is more of it, so the impact on prices may not be meaningfully greater than for other assets. And of course, the ECB now owns a large part of some sovereign markets, so it would need to change the rules to allow further large-scale purchases.
 


If we focus on spreads (as per chart below), there may be more to go for in Italy and Greece than in other markets but the risks are also greater. Ironically, the ECB’s capital key rules suggest it actually exerts more pressure on the German bond market than on peripheral markets because the debt/GDP ratio is lower (though liquidity may be higher). We suspected Italy’s government bonds would outperform the rest of the eurozone earlier this year, given the back up in spreads due to policy confrontations with the EU. Figure 7 suggests that may still be true for the rest of the year (though a lot of the road has already been travelled).




Among corporate debt, the yields on high-yield are clearly more interesting but the risk is that recession would cause them to widen. This said, default rates are low present, and further easing might help avoid the increases in default rates that normally accompany a recession.
 

So, in sum: in response to the next round of ECB easing, we would expect European – and global – investors to increase exposure to a short list of asset classes: Italian sovereign debt; high-yield in general; COCOs and bank sector equities; emerging markets; and of course, the United States.


Arnab Das is Invesco’s Global Market Strategist in the EMEA region. Paul Jackson is Global Head of Asset Allocation Research for Invesco. Luca Tobagi is Invesco’s Investment Strategist.
 

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