UK
Inflation Report: BoE Not Anticipating Tightening Monetary Policy Soon
May 15, 2009

By Melanie Baker, CFA | London

Risks of later, rather than sooner, policy tightening: We had expected the first tightening in monetary policy to be before the end of the year. However, the MPC’s central forecasts for GDP growth and inflation look similar to our own for much of 2009.  Despite that, the MPC does not appear to anticipate tightening policy for quite a while.  If the 1% or so of growth in GDP that we expect over the rest of 2009 won’t positively surprise the MPC, the committee may well not be moved to raise rates by the end of the year. A first policy tightening in 1Q10 now looks somewhat more likely than in late 2009.

The MPC’s new central inflation forecasts show inflation relatively close to the target in the medium term, but only in the profile which assumes that interest rates stay at 0.5% and the stock of purchased assets stays at £125 billion for the entire forecast period (i.e., to early 2011).  When market rate expectations are plugged in (i.e., rate rises over 2010 with 4Q at 2.1%), inflation is significantly below the target two years from now.

An early exit still possible: Why do we think that the MPC still might raise rates before the end of the year?  1) The recovery may start a bit earlier than the MPC appears to anticipate. Its very near-term GDP growth forecasts look weaker than ours. An earlier recovery may lower its estimate of spare capacity and therefore raise its inflation forecasts. 2) The marked downward skew in the MPC’s forecasts for GDP growth is likely to lessen as the year progresses, as the economy (here and abroad) recovers somewhat and as the MPC becomes more confident of the positive effects of policy stimulus. 3) If the MPC succeeds in persuading people that nominal interest rates are likely to stay at extremely low levels for a prolonged period and real GDP growth picks up as we expect in 2009, there is some risk that more medium-term inflation expectations start to pick up too.

Why did the BoE increase the amount of asset purchases at the May monetary policy decision? There was a downward GDP growth revision in the Inflation Report, despite the MPC sounding fairly comfortable with its forecasts in preceding meetings.  The MPC effectively lowered its central projection for GDP growth somewhat throughout the profile (and widened the distribution). This is the result of lower-than expected output in 1Q and a judgment that it will take longer for bank lending to return to normal than it previously assumed. 

In terms of the recent more positive signals in surveys, Governor King made the point that these say little about the persistence of any improvement in the outlook. The MPC thinks that a sustained economic recovery will take time, suggesting that the recovery in economic activity will be relatively slow. Further, the Committee has more confidence in the broad shape of the GDP fan charts than on its precise calibration.

MPC expecting a non-inflationary recovery: The MPC forecasts that inflation will stay below the 2% target (again on its central projection) for the forecast horizon. That’s in the scenario where interest rates stay at 0.5% and the stock of asset purchases stays at £125 billion. And that’s despite again showing a central forecast for real GDP growth which looks consistent with looking for positive quarter-on-quarter GDP growth in the second half of the year and actually a relatively robust recovery in real GDP growth. The main reason for this very subdued inflation profile is the significant amount of spare capacity that the MPC expects to be bearing down on inflation. 

An expectation of low rates ‘for longer’ is not the same as a commitment to keep rates low for longer: It is one thing to suggest that the MPC anticipates keeping interest rates very low for a prolonged period of time; it is quite another to suggest that it’s committed to anything. There is a huge margin of uncertainty baked into the fan charts. Governor King stressed during the press conference that he felt there was no merit in committing to keeping rates at a low level for a considerable period when no one can anticipate what will happen in the future with any approximation of certainty (especially in the current environment) and again emphasised that the outlook for inflation would determine policy.

More broadly on exit strategy, the MPC’s inflation forecast would suggest that it doesn’t anticipate exiting anytime soon. However, in response to a question at the press conference, Governor King said that the exit strategy would be a combination of raising the bank rate (i.e., the Bank of England’s ‘policy’ rate) and selling assets. The decision will be based on the outlook for inflation. When the balance of risks to inflation points to inflation moving above the target in the medium term, it’ll choose the combination of asset sales and interest rates rises. Crudely extrapolating forward the profile for inflation (i.e., assuming that the world evolves in line with the MPC’s central expectation and with unchanged monetary policy) suggests that this situation could arise within two or three more Inflation Reports (i.e., by February 2010 and possibly as soon as November 2009).

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Euroland
Not Quite QE at the ECB
May 15, 2009

By Elga Bartsch | London

Covered bond buying is not the start of targeted QE: At the last press conference, the ECB surprised us and the markets by announcing that it would start buying about €60 billion of covered bonds.  Many observers initially viewed this as the start of targeted quantitative easing (QE) by the ECB.  We disagree.  It seems to us that the main aim of this policy initiative is not to ‘pump liquidity’ into the market or to indeed ‘print money’.  In our view, the ECB has been in (passive) quantitative easing mode ever since it started to expand its balance sheet.  At this stage, however, the ECB seems to judge the amount of liquidity the banking system is taking down as sufficient and does not see a need to force additional liquidity into the system. 

Purchases could even be sterilised but probably don’t need to be: Based on comments by ECB President Trichet at the press conference, we would therefore not rule out that the ECB would contemplate sterilising its covered bond purchases – either right from the start of its buying programme or at a later stage.  But such a sterilisation probably won’t be necessary, we think, as banks are likely to adjust their bids at the various refi operations downwards to the extent that they are able to sell covered bonds to the ECB under the new scheme.  In what follows, we discuss the interest rate outlook for the euro area and the ramifications of the introduction of ultra-long refis, and outline what shape the ECB’s covered bond purchases will likely take.  We conclude by suggesting some investment ideas.

Refi rate to stay unchanged at 1% now for an extended period: As expected, the ECB cut the refi rate to 1% while leaving the deposit rate, which effectively sets a floor for the overnight rate (EONIA), unchanged at 0.25%. Contrary to our conjecture a few months back, the ECB will likely keep the floor for EONIA at this level (see EuroTower Insights: ECB to Enter ZIRP? January 7, 2009).  In order to keep the corridor around the refi rate symmetric, the Council lowered the marginal lending rate at which banks can obtain emergency overnight funds by 50bp to 1.75%.  Going forward, we expect the ECB to leave the main refinancing rate at 1% for an extended period, mostly likely until the middle of next year.  In our view, it would take a major downside surprise on growth and inflation to cause the ECB to cut rates further.  What will likely be a very marked downgrade in the ECB’s June staff projections or what will likely be a rather rapid rise in the unemployment rate over the summer won’t suffice to trigger another rate cut, we think. These developments have been anticipated by the ECB when it came to its verdict that “interest rates are appropriate”.

As activity seems to be stabilising, further rate cuts are unlikely: The coming downgrade to the ECB’s growth projections – like that of many other forecasters – mainly reflects a worse-than-expected outcome for 1Q GDP. As such, the 1Q GDP data, for which a first flash estimate will be released later this week, is backward-looking information.  If it indeed turns out, as we expect, that part of the reason for such a sharp contraction in activity between December and March was that production was cut more aggressively than demand and a sizable negative growth contribution from inventories resulted, the implications for the outlook in the rest of this year could actually be positive. Together with some timid green shoots starting to show here and there, the ECB’s conjecture of a mild contraction in activity in the rest of this year and an only very modest recovery next year might turn out to be too gloomy (see Growth Is Bottoming Out, but Don’t Get Too Excited (Yet) About ‘Green Shoots’, May 6, 2009).  As a result, we would attribute only a small (subjective) probability to a further ECB rate cut.  If at all, such a rate cut would be unlikely to come before the summer recess, we think.

New ultra-long refis give euro area banks visibility… Yet, even without further refi rate reductions, the ECB’s decision to offer a longer-dated refinancing operation with a maturity of one year starting from June 23 will likely impact the euro area funding markets.  At the time of writing, one-year Euribor rates were still significantly above the ECB refi rate.  The new ultra-long refis will be conducted at end-June, end-September and end-December.  To ensure that banks have an incentive to bid for the ultra-long refis from the start, the ECB announced that only the first operation will take place at the refi rate, while the other two operations could be conducted at a spread over the refi rate.  Note that this spread also gives the ECB some leeway in monetary policy terms, if towards year-end another 12 months of bank funding costs at 1% seems rather generous.  As with all other refi operations, the ultra-long refis will also provide unlimited liquidity to the banking system against eligible collateral in a fixed-rate auction with full allotment.

…and could also be key for the ECB’s exit strategy: As we have argued before on these pages and in the ECB Shadow Council, refi operations have a number of operational advantages over outright purchases, both for the ECB and for the banking system (see “A Different Unconventional Measure”, The Global Monetary Analyst, April 29, 2009). 

In addition, the ultra-long refi operations allow the ECB to start its tightening campaign – say, if next summer inflation expectations started to rise rapidly – without massively increasing bank funding costs.  Only the short-term funding needs, which banks did not cover in the ultra-long refis, and of course money market rates would be affected by a refi rate rise in June 2010.  So, the ECB would be in the position to send a policy signal to both bond market investors as well as wage and price-setters in the real economy that it won’t tolerate a build-up of longer-term inflation risks without at the same time jeopardising the healing of the financial sector.

Enter the EIB as an eligible counterparty: Another interesting twist to the ECB’s operational framework was that the European Investment Bank (EIB) will become an eligible counterparty.  This will give the EIB, which is co-owned by all European governments, access to the ECB’s refinancing operations from July 8 onwards.  Like all other counterparties, the EIB will be able to borrow from the ECB against collateral, which can include anything from marketable and non-marketable fixed income securities to its own loan book.  The EIB typically finances projects which further objectives of the European Union.  Strong demand for its lending programmes suggests additional funding needs.  These will now in part be covered by the ECB refi operations.  The EIB’s lending priorities include cohesion and convergence (in particular in Central and Eastern Europe), support for small and medium-sized enterprises (SMEs), environmental sustainability, clean energy, innovation as well as Trans-European transport and energy networks (TENs).  Its EU recovery package, approved by the ECOFIN in late 2008, comprises of lending to particularly vulnerable or important sectors (e.g., cars) and regions (e.g., CEE), to SMEs and for funding energy and climate change initiatives.  The EIB itself estimates that it will get additional funding from the ECB of around €10 billion. 

The big one: Buying covered bonds: Last but not least, the ECB announced that it has, in principle, decided to start purchasing about €60 billion of covered bonds.  Contrary to other central banks such as the Federal Reserve or the Bank of England, the ECB does not view these outright purchases as QE.  Instead, the ECB views it as “enhanced credit support” for a particular market segment that is key to funding banks and whose “smooth functioning … is important from a financial stability perspective” (see Covered Bonds in the EU Financial System, December 2008).  Hence, the ECB is clearly sticking to its aim to support the bank credit channel.  Given that the ECB will likely purchase a good 10% of the overall Jumbo market, a market which has only seen about €18 billion of issuance so far this year, according to our interest rate strategy team, the programme will likely cause covered bond spreads to come in (see Interest Rate Strategist, Pedal to the Metal, May 8, 2009).

Nitty-gritty not known until June though: The technical details of the buying programme will only be announced at the ECB’s June meeting.  However, it is already clear that only covered bonds issued in the euro area denominated in euros will be eligible for the €60 billion programme. 

• In our view, the ECB will likely limit purchases to the Jumbo market, as its general operational guidelines for outright transactions stipulate that it should only buy marketable securities and it probably wants to revive what used to be an actively traded market.

• The operational guidelines probably also imply that the ECB is more likely to be active in the secondary market than the primary market for covered bonds.

• Another decision the ECB needs to take is whether it will purchase all covered bonds or whether it would limit itself to some sub-segment of the covered bond market backed by mortgages, by ships and/or by public sector loans.  While purchasing public sector loan-backed covered bonds probably does not constitute a conflict with the Maastricht treaty, one could argue that it is mortgage-backed covered bonds and, also, the shipping segment that are more in need of a lift.   In this case, the pool of assets available for purchases by the ECB would only constitute about 60% of the total covered bond market.

• There is already a lot of talk as to which euro zone countries would be targeted by the ECB’s buying programme.  However, we deem a breakdown of the buying programme by nationality of the issuer unlikely.  In our view, a country-based approach would conflict with the spirit of one of the very few truly European institutions and its efforts to foster financial market integration.  In addition, targeting one or several countries specifically in its buying programme could easily be counter-productive if the market came to the view the ECB “knows something” about the state of banking system in that country. 

• In our view, it is therefore more likely that covered bonds from different countries will be treated equally and that the parameters defining the buying programme are given by the maturity, the coupon, the credit rating and, possibly, the collateral pool underlying the bond.  These parameters together with the bids/offers by eligible counterparties will at the end of the day determine the country allocation.

Keep options open on sterilisation: At the press conference, ECB President Trichet left it open whether the ECB would potentially consider sterilising its covered bond purchases.  In our view, such a sterilisation is likely to remain hypothetical, as it would seem likely that banks will adjust their bids at the refi operations downward.  In addition, the ECB gave up control over liquidity when it switched to a fixed-rate tender with full allotment in October 2008.  Since then, liquidity has been entirely determined by banks’ bids.  For now, the ECB seems to view the liquidity the banking system is taking down as sufficient and does not see a need to push additional liquidity into the system.  On the off-chance that the ECB would decide to sterilise, it could do so by either issuing ECB debt certificates or by selling other assets on its balance sheet. We would deem the first measure marginally more likely.  As such, we view sterilisation as part of the ECB’s eventual exit strategy.  Bond market investors should take note that the ECB seems to be the only major central bank that already has an exit strategy in place.  And a rather good one, we believe, if you consider the buffer ultra-long refis provide for the banking system.

Based on the outcome of the ECB meeting, our European interest rate strategy team recommends the following trades:

• Long duration in 5Y;

• Curve steepener from 5Y out (e.g., 5/10 steepener);

• German swap spreads to narrow further;

• Long covered bonds issued by euro area issuers.

 For further details, see Interest Rate Strategist, Pedal to the Metal, May 8, 2009.

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