A New ECB Outlook: Part II
As argued in Part I of this posting, the European Central Bank (ECB) has tiptoed toward a policy of monetary easing but is unlikely to act quickly. Here I discuss what the ECB might do in the second half of 2014, if the inflationary environment continues to deteriorate.
One factor likely to delay ECB action is the asset quality review (AQR), or stress tests, of major banks, to be completed by the end of October, at which time some banks may need to repair their balance sheets. A balance sheet repair in an atmosphere of uncertainty will naturally affect bank lending and possibly discourage the ECB from promoting higher credit volumes and lower bank lending rates. Any additional ECB asset purchases thus look possible only towards the end of 2014.In a recent speech, Benoît Cœuré, a member of the ECB’s governing council, suggested that the ECB would not duplicate the quantitative easing (QE) of earlier interventions in purchases of sovereign debt by the Federal Reserve, the Bank of England, and the Bank of Japan, which would require several trillions worth of asset purchases of euros.1 Such a scope of action would never be contemplated in the absence of another emergency.
Cœuré emphasized, however, that the ECB can invoke Article 18 in the European System of Central Banks (ESCB) Statute to purchase any private outright claim and marketable instrument it deems necessary. He further noted three additional considerations for the ECB in designing any future asset purchase program.
First, it would appear the ECB plans to direct its possible purchases at assets with maturities of three years or more, thus lowering interest rates for the loans that euro area firms and households rely on for investment consumption. The strategy of targeting three-year maturities is a far more effective means of signaling intentions on rates than forward guidance. 2
Second, in the continued absence of a single pan–euro area yield curve (i.e., eurobonds) only some euro area countries—presumably those with the highest long-term interest rates—would be targeted.
And third, only some financial assets in individual euro area countries will be targeted to reduce relevant longer-term rates. All told, Cœuré suggested that the success of a complex and surgically targeted asset purchase program for the euro area, should one become necessary, would be measured by its effect on certain asset prices and interest rates. The implication is that the ECB will focus on pushing down interest rates in the periphery and not the core euro area economies. Purchases of French, German, and core euro area bonds are thus highly unlikely.
Coeuré does not address whether the ECB would purchase any euro area sovereign bonds as opposed to euro area bank bonds and corporate bonds. The ECB is obviously keen on restarting the European market for high-quality asset-backed securities (ABS), as the total ABS market in the euro area is currently stuck at around just €1.5 trillion. As noted in a recent ECB–Bank of England paper [PDF]:
“From the perspective of central banks, securitization can play an important role in supporting both monetary and financial stability. In the current fragile macroeconomic environment, for example, high-quality ABS can support the transmission of accommodative monetary policy in conditions where the bank lending channel may otherwise be impaired. In particular, securitization may allow banks to lend without committing too much capital and other sources of funding, and thereby provide indirect market access to groups of borrowers that are otherwise not able to tap markets directly, such as SMEs [small and medium enterprises].”
A well-functioning ABS market will therefore be a crucial part of the tonic needed to reduce or eliminate the persistent fragmentation of bank lending rates in the euro area. Such a market might also provide more relevant private assets for purchase if the stress tests fail to lower lending rates by banks, a point made earlier on RealTime. The AQR and the ECB’s new role as banking supervisor should give the ECB more information about the quality of the bank loans it might purchase. (After all, no Chinese wall really exists between the ECB’s monetary and regulatory functions.)
Indeed the ECB’s ability to protect itself against credit risk from ABS purchases rises after the single supervisory mechanism (SSM) enters into force. On the one hand, as a monetary policymaker, the ECB would in fact want to purchase ABS loans from euro area banks to spur economic growth and inflation. On the other hand, as a supervisor, the ECB will be watching to ensure that banks do not overextend their credit provision. Both parts of the ECB will guard against banks selling it toxic loans.
Would euro area banks be willing to sell their loans to the ECB? Banks typically argue that, when demand is lacking, they cannot increase lending to risky small and medium businesses without incurring too much credit risk. They would thus be unlikely to part with higher quality loans unless there is a financial sweetener. The ECB itself will be unlikely to provide such incentives, though the European Investment Bank, the European Commission, or even the European Stability Mechanism (ESM) might do so. The problem is that such complex considerations prevent engaging in a large-scale asset purchase program that would make a difference. The question remains, however, whether sovereign bonds will be included in any future ECB asset purchase program, or whether the ECB feels it can lower the relevant asset term premia in the relevant countries without buying them. Politically, the ECB will find it easier to avoid buying government bonds, as such purchases will raise knee-jerk legal skepticism in some countries (e.g., Germany). The question is not whether such purchases are legal. Properly structured, they are certain to be ultimately deemed legal by the European Court of Justice. Rather, the question is whether ECB purchases will result in the intended reduction in yields and what yield levels the ECB considers appropriate.
It is instructive to start with a look at the different sovereign bond yield curves in the euro area in figure 1.
Figure 1 shows that Germany unsurprisingly has the flattest yield curve in the euro area, followed by France. Both countries lie below the US and UK yield curves. Remarkably, Ireland is somewhere in between. Italian and Spanish yield curves are similar. Until around the 5-year point, they are approximately equal to the US/UK level, after which spreads rise to around 50 basis points for 10-year bonds and 80 basis points for 30-year bonds. Italian and Spanish yields remain above Germany’s with a range from around 80 basis points for 3-year debt and 180 basis points for 30-year bonds. Portugal’s bonds are about 50 to 80 basis points above those of Spain and Italy, while Greece remains above these levels, though far below what most would have thought possible for the Hellenic Republic a few months ago.
The recent declines in peripheral bond yields have flattened the curves in figure 1. Term premia for Spain and Italy are today in most cases only between 50 to 100 basis points above their precrisis levels. Their longer-term bond yields are also at record lows.
What long-term bond yield and term premia would the ECB target in any asset purchase program? To avoid deflation, the target for peripheral countries should be low, perhaps around where France and Germany are today,3 effectively eliminating sovereign bond yield spreads among the major euro area economies.
The ECB, on the other hand, views some spreads among euro area sovereign bond yields as healthy in disciplining various countries and would not want to return to the bad old precrisis days of excessively small spread among euro area members. A more realistic target would be to bring Spanish and Italian yield curves to the current levels of the United States and the United Kingdom, which continue to benefit from QE asset purchases by the Fed and the Bank of England. Or given that Spanish and Italian sovereign yields are today at a more healthy level, the ECB should instead focus its purchases on private assets elsewhere in these economies.
At least some part of the recent rally in peripheral bonds (except for Greece) seems related to private investors wanting to get into these markets ahead of any assumed ECB purchases. Such investors would be disappointed by ECB inaction and might sell their holdings, reversing the recent gains on rates if new private investors fail to materialize.
All told, the ECB is unlikely to include a sizable amount of euro area sovereign bonds in any future asset purchase program, although a reversal of recent price gains might force Frankfurt’s hand.
As discussed earlier on RealTime, the ECB governing council might instead condone the purchase of asset-backed debt or bonds by national central banks, removing any political concerns about the hypothetical fiscal transfers from rich countries to ailing countries implied by the use of the ECB’s own balance sheet.
Whatever the ECB decides to do, it will be a different beast from anything implemented by other central banks. Whether it would qualify as “quantitative easing” in terms of scale, intention, and execution remains to be seen.
1. See Francesco Papadia for results between €2 trillion and €4 trillion.
2. In its program of sovereign debt bond purchases, the ECB has defined short term as up to three years. From this one can infer that Coeuré’s use of the term “intermediate to long” as likely meaning that time frame.