Van een politiek naar een economisch rentebeleid: de ECB onder Draghi

We hebben het gisterenavond, tijdens het lijsttrekkersdebat, weer kunnen horen van onze premier: de rente van de ECB is geen economische maar een politieke variabele, bedoeld om landen onder druk te kunnen zetten. Kijkt de ECB daar, onder Mario Draghi kijkt de ECB daar in toenemende mate anders tegenaan? Lees mee met Erwan Mahe.

The ECB lowers our expectations

    20 August 2012
I haven’t written much of late. After all, I was on vacation and didn’t want to put a jinx on the current Risk On movement we had been expecting since June/July. Yes, I know this attitude doesn’t have much to do with the “Theory of Efficient Markets,” but is there anyone out there who truly believes in them these days?

However, the ECB’s denial this mid-afternoon calls for me to respond in writing since it is important and justifies a temporary peak on Risk On assets, which pushed our clients to take profits on their large beta bets (financial shares) and hedge their short Bund positions. This morning, we even had a little luck in setting up long strategies on Bund via options (call spreads and October call Flies), but for technical reasons. (See however in the Asset allocation part at the end of this letter why Asmussen’s statements should prevent anyone to put any Risk OFF trades on)

 Here is the ECB statement verbatim:

 As regards today’s reporting by the magazine Der Spiegel, please be informed that the following statement can be attributed to an ECB spokesperson. It is free for immediate reporting.

 “1. It is absolutely misleading  to report on decisions, which have not yet been taken and also on individual views, which have not yet been discussed by the ECB’s  Governing Council, which will act strictly within its mandate.

 2 As far as recent statements by government officials are concerned, it is also wrong to speculate on the shape of future ECB interventions. Monetary policy is independent and undertaken strictly within the ECB mandate.”

 This sort of announcement is sufficiently unusual for it to be highlighted since it is rare indeed for the ECB to feel the need to respond to a press report.

It is true that the article in question from Spiegel, published Sunday, which presented itself as a pre-announcement of the ECB’s decisions, was both a demonstration of boldness, long since abandoned by those who used to try and predict ECB decisions in recent years, and utterly wacky.

The report started from the premise that the European Central Bank was ready to use the infinite size of its balance sheet, a bit like the Swiss National Bank did to block the Swiss franc at €1.20 by purchasing all Eurozone government bonds which exceeded a certain yield spread vis-à-vis German bunds.

 While such a measure is theoretically possible, given that the ECB indeed has no limit in the amounts in can use in this type of operation, two factors lead me to believe that it will announce no such measure on September 6th.

 A. The ECB will initially limit any intervention to the short segment

 Its intervention will logically focus on the short end of the yield curve because that is where it must begin to restore its monetary transmission channel. I wrote extensively on this matter last December, so I will just state here that it is a matter of “monetary mechanics”.

Contrary to what its bylaws may lead one to believe, the ECB really has no direct control on the quantity of money in circulation in terms of M3, which it initially wanted to keep around 4.5% per annum. We have already demonstrated just how much they failed, given that it oscillated between 5% and 14% (!) from 2001 to 2007 before plunging to 0% in 2009 and 2010 and then finally climbing to just +3.2% in 2012. The ECB does not control monetary creation. Money is endogenous and, in practice, it is commercial banks that determine changes in the quantity of money in accordance (or not) with credits (as in “loans make deposits”)!

 As a consequence, the ECB can only indirectly control the quantity of money via changes in benchmark interest rates to influence the cost of loans granted by banks and thus the economy’s aggregated demand and changes in inflation.

That said, in order for this type of move to be effective, the monetary transmission channel must be functional, which means that the changes made in benchmark interest rates must spread to the other relevant market rates and extend to the entire length of the yield curve.

Given this outlook, the ECB’s initial moves must focus on the short end of the curve. That is what it did with the LTROs and its reductions in benchmark interest rates, which led to a major decline in the 3-month Euribor from 1.60% in October 2011 to 0.32% today and 0.22% anticipated for December 2012 to June 2013.

But the Euribor rates, which ire supposed to reflect the interest rates at which banks with surplus reserves grant unsecured loans to banks in need of liquidity, are totally out of whack, since banks are no longer lend without collateral.

Due to the vicious sovereign debt/bank balance sheet situation cycle, commercial banks in the Eurozone have in fact become completely dependent on the financial soundness of their country. Not only are loans made to the economy calculated on the basis of a government + a margin but commercial banks also have structurally (Basel III) a large stock of short-term government bills in their portfolios, many from their own country.

 As such, when sovereign debt interest rates take off (Spain, Italy), loans to the economy mechanically become more expensive and bank balance sheets find themselves in a delicate situation, further restricting credit access (deleveraging).

Given the conjuncture of these two factors, in accordance with its mandate, it is necessary for the ECB to do some housecleaning on the short end of the curve of distressed Eurozone countries, especially since they are the most in need of the lowest real interest rates but are being hard hit by the highest ones!

B. The ECB will not take into account the level of spreads vis-à-vis the Bund

 This scenario advanced by Spiegel, among others, is based on no macro foundation but on old “vows of uniformity” which have long since been superseded by events.

As we saw, above, what interests the ECB is that its benchmark interest rate decisions impact the short end of the curve. The important spread is thus not that between the BTP or the “Bonos” and the bund, but that between these sovereign rates and the refi rate!

In normal times, the latter spread may vary depending on expectations of changes in benchmark interest rates, but in the context of a monetary floor policy (ZLB) in the foreseeable future, it should be stable and close to 0. That means sovereign debt interest rates on 2-year maturities at around 0.75%. Even that is high in the current economic context and justifies that the ECB lower further its key rates, with 2-year rates in Japan, the US and GB amounting to just 0.10%, 0.28% and 0.16%, respectively.

The interest rates on German government debt falling into negative territory is just as aberrant and simply reflect the flight to safety, which is analogous to similar shifts on German and Danish debt, but inconsistent with the current economic situation in Germany. That country’s economy is the most buoyant of the Eurozone and, from a purely monetarist standpoint, that is precisely the country where interest rates should be highest!

The constraints of the euro have changed things and I suspect that the other Eurozone countries are delighted that Germany is benefiting from such an ultra accommodative interest rate climate since that can only help resolve certain intra-zone disequilibria (inflation differentials and saving/consumption mix).

 The ECB will thus set targets for its interventions on the short end of the curve, no spread target vis-à-vis the German benchmark but absolute rates depending on its monetary policy target points.

Without going so far as to bring 2-year Spanish and Italian rates to 0.75%, it could very may bring them down to below 2%. Today they are 3.04% in Italy and 3.58% in Spain. Such a decline in sovereign debt interest rates for these countries will have a major positive impact on the balance sheets of domestic commercial banks, thereby magnifying the program’s impact on their domestic economies.

C. Further comment with no small dosage of irony

 Given that, in exchange for a bailout from the ECB, these countries (Spain and Italy) must carry out “light” reform plans, why wouldn’t the ECB intervene in the same way on the short-term government debt markets of countries which have already agreed to “heavy” reform plans (Portugal, Greece, Ireland)?

To not do so would be theoretically (and morally) totally unjustifiable and doing so would enable those countries to return earlier to primary market thus reducing the load from the backs of their “official” lenders. And it would have the same positive impact on domestic banks. We could thus go from a vicious circle to a virtuous one!

That is all I have to say for today. I realize that I am taking a chance by predicting what the ECB will or will not do, but I have to do find usage for those thousands of hours of theoretical research (did you notice that I changed the adage in the Thaler’s Corner banner today?). After all, pretension is my only defect, right?

(Ha! ha!)



As a bonus, check out this updated graph of aggregate 2-year interest rates for the Eurozone. This is the same graph I used in December for the study on the “Monetary Transmission Channel”.


Leave a Reply