The ECB’s next meeting will be Christine Lagarde’s first real test as new ECB President – marking an end to a honeymoon-like period in which she was planning to focus on the central bank’s strategic review. Instead, we expect the ECB to announce a battery of measures to counter the ongoing market and economic disruption, including:
- Credit measures: we expect the ECB to help improve European companies’ access to credit. This could include an easing of the conditionality criteria of the Targeted Longer-Term Refinancing Operation (TLTRO) loans (cheap loans to banks in order to foster bank lending). The ECB may also launch a new subsidized loan programme tailored to corporations’ working capital needs.
- Macro measures: the ECB may double its net asset purchase programme to €40 billion per month over the next six months.
These measures would be supportive for European spread assets, such as corporate credit, and also act as a bridge to fiscal policy, which markets now expect governments to unveil. However, and in the current volatile environment, it remains particularly uncertain whether these measures will be perceived as enough and whether elected government officials will respond in scale and time.
If an increase in the asset purchase programme proves unsuccessful in arresting the violent spread widening recently seen, the ECB might at some stage contemplate more targeted interventions in sovereign debt markets. Such move would aim to address tensions in dysfunctional market segments, especially those that are hampering the credit flow between banks and borrowers, and therefore challenging the effective conduct of monetary policy.
More asset purchases?
Any ECB increase in net asset purchases will necessitate an increase in the public sector issue and issuer limits, from the present 33% - we believe this could be raised to 50% at this week’s meeting.
We could also see a tilt in the sector allocations of the asset purchase programme towards private sector assets, though it is less likely that the ECB would explicitly announce such a shift in advance. In order to make the net asset purchases more effective, the ECB may also allow some temporary deviations from its capital key guidelines (how much each national central bank contributes to the ECB’s own capital). However, we would expect the current capital key to remain a guiding principle over the medium to longer term, with any deviations ultimately being reversed. We also believe that additional asset classes are unlikely to be included at this stage.
We are less convinced about the probability of a rate cut and err on the side of the Governing Council leaving the deposit facility rate unchanged at -0.5%, given its limited effectiveness. Instead of cutting rates, the ECB might prefer to stimulate credit via its loans programme in order to smooth the transmission mechanism between banks and companies and people. The flow of credit into the market could even worsen in the medium term, and igniting action into it could be a more efficient way to reverse Europe’s dire inflation outlook and any potential tightening of financial conditions.
The absence of a rate cut may help sustain recent euro strength, which is undesirable in an export-dependent continent. However, it is unclear whether cutting rates by 10 basis points (bps) further into negative territory would help the currency much, apart from adding more damage to the already beleaguered European banking sector, which needs higher interest rates to keep profit margins intact.
Also, the effects of an interest rate cut are more difficult to reverse, while asset purchases can be more easily scaled up and down, and TLTRO conditions can be changed. But, since a cumulative 20 bps of cuts are priced in, a 10 bps reduction is certainly a possibility to validate market pricing and also to highlight that rate reductions remain part of the toolkit. To counter the negative effect of any rate cut on banks, the ECB may change the tiering quota exempting banks’ required reserves from the penalty rate. Financial institutions may welcome such a move, especially as we also expect the ECB to downgrade its macro staff forecasts, relative to December projections.
Regardless of the precise package of measures the ECB unveils, some form of monetary and fiscal cooperation will be crucial to overcome the virus-related shock to aggregate supply and demand, and also to tackle the disinflationary environment in Europe. The ECB can’t do it alone.
Stay with us - we will come back at the end of this week with more comments.