ECB Asset Purchases – Bazooka Or Damp Squib?

The recent policy announcement by the European Central Bank (ECB) was warmly received by financial markets as Mario Draghi reaffirmed his commitment to meeting the medium-term inflation target. However, inflation expectations have since returned to the levels that inspired the governing council to commit to private sector asset purchases at its September meeting. Is the market telling us that policy is impotent against the gathering deflationary forces?

Inflation expectations

The measure of inflation expectations cited by Mario Draghi as justification for policy easing, the 5-year 5-year forward inflation breakeven (Exhibit 1), has remained remarkably stable over recent years as the spot CPI has ebbed and flowed. In fact, it has only dipped below 2% on a couple of occasions at the height of the financial crisis. It is for this reason that a mere15 basis points fall in the measure was enough to spark panic. During August, the five-year measure fell as low as 1.94% before rebounding to 2.05% on the day of the ECB meeting. In recent days, it has fallen to 1.93%. 10-year breakeven rates (Exhibit 2) in the index-linked bond market have exhibited a similar trend, although five-years have remained higher. Should we infer from this information that the policy measures announced are thus insufficient, and a more aggressive policy is now required?

Exhibit 1: Eurozone, 5yr5yr forward inflation

Source: Bloomberg, Sep14.

Exhibit 2: German breakeven inflation

Source: Bloomberg, Sep14.

Technical factors make inflation markets difficult to decipher

Firstly, there are some technical elements that should be considered. For example, anecdotally it appears that many market participants had prepared for the ECB announcement by putting on trades in anticipation of higher inflation expectations. The initial reaction has inspired profit-taking and pushed expectations back down. Furthermore, the inflation-linked market is characterized by illiquidity and seasonal distortions. Consequently, it is difficult to make firm conclusions over a short time horizon. Nevertheless, an ECB board member looking at these measures two weeks after the policy announcement would not be terribly encouraged.

Inflation expectations have been falling elsewhere too

Although the ECB is under the most pressure of all the central banks to combat falling inflation, expectations have also fallen in other economies (Exhibit 3), inspired by weakness in commodity prices and subdued global growth. Therefore, it could be argued that the recent move is a global phenomenon. Of course, Europe has the worst starting point, but the ECB should not try to combat global factors such as energy prices. Indeed, low commodity prices should be good for growth. From this perspective, the decline in inflation expectations is less alarming. The reaction of the nominal bond curve also suggests that the market is optimistic about the impact of the recently announced policy action, having steepened sharply in the aftermath of the ECB announcement. If the 30-year yield (Exhibit 4) were to retrace back towards the recent low of 1.75%, this would be another warning sign.

 Exhibit 3: U.S. 10-year break-even inflation

Source: Bloomberg, Sep 14

Exhibit 4: 30-year Bund yield

Source: Bloomberg, Sep 14

ECB ‘shock and awe’ policy is no Fed QE

The ECB would argue that its policy will take time to have an impact. The key tangible metric in measuring how much stimulus is entering the system is the size of the ECB balance sheet. With respect to historical iterations of QE, in the U.S., Japan and UK the size of the buying programme has been known in advance. Despite the hint that the ECB intends to boost the balance sheet by €1 trillion (Exhibit 5), the figure remains uncertain because of the nature of the policy. There are certainly question marks surrounding the likely take-up of the longer-term refinancing operations (TLTROs) and the potential size of asset-backed securities (ABS) purchases. It is therefore quite understandable that the market will take some convincing regarding the potency of the policy. Any sign that liquidity is building on a larger scale than expected would soothe investors’ concerns. The first TLTRO operation saw a take-up of €82 billion, which was on the low side of expectations. It is unclear as yet how much of this is fresh liquidity and how much is the replacement of previous repo operations. Excess liquidity (Exhibit 6) is the key metric to keep an eye on, and has been in decline in the Eurosystem for some time. The ECB is keen to reverse this trend.

Exhibit 5: ECB balance sheet

Source: Bloomberg,Sep14

Exhibit 6: Eurosystem excess liquidity

Source: Bloomberg, Sep 14

An increase in liquidity will boost monetary accommodation at a time when interest rates are at the lower bound, and also aid the transmission mechanism as more cash becomes available for lending to the private sector. This should boost inflation expectations but there is currently too much uncertainty regarding implementation and effectiveness.

Policy buys time for recovery to re-ignite

The stuttering growth outlook was another factor that inspired the ECB’s policy response, as forward looking indicators have continued to decline following the weak reading for Q2 GDP. A continued decline in the growth momentum would surely reduce inflation expectations further and increase the likelihood of more policy action from the ECB. Recent indicators suggest that the economy is on track to grow by 0.3% in Q3 (Exhibit 7), which would be welcome. Headline CPI data is also due to edge higher into the year-end. Spot headline inflation is an important determinant of forward-looking inflation expectations (Exhibit 8), and has been affected negatively by the consistent downside surprises in the monthly data this year. If CPI fails to recover above 0.5% before year end, this could have a further detrimental impact. The recent depreciation of the euro should lead to higher headline inflation at the margin.

Exhibit 7: Euro Area GDP vs. PMI

Source: Bloomberg, Sep 14

Exhibit 8: Inflation expectations vs. headline CPI

Source: Bloomberg, Sep 14

Sovereign QE still a step too far for the ECB

Following the commencement of private sector QE, the final frontier for monetary policy is sovereign QE. Further weakness in inflation expectations will increase pressure on the ECB to go one step further and begin buying government bonds. Comments made since the September meeting suggest that there are still significant hurdles to this policy. Vice President Constancio sums it up best:

“We are convinced that we are allowed to buy government bonds in the secondary market, if it is justified by monetary policy considerations. But we also know what it means and this is certainly something we would prefer not to be forced to do.”

This re-enforces the idea that the ECB will want to wait to ascertain the impact of recently-announced measures given the institutional difficulties associated with sovereign purchases. An increase in the size of ABS purchases is a possible half-measure although it will remain debateable how much ABS is available to buy. Only a further significant deterioration in either the growth outlook or inflation expectations (five-year, five-year <1.75%) would force the ECB into sovereign bond purchases this year.

Summary

The ECB will likely not be wholly impressed by the reaction of inflation expectations to recently announced measures, and will be keeping a close eye on favored measures. However, they will likely want to wait to see the impact of recently announced measures before taking further action. We believe that we would need to see a further significant deterioration in growth and inflation expectations to kick the ECB into further action before year end.