Why the ECB will not turn Ja­panese

Financial Mirror (Cyprus) - - FRONT PAGE - By Cedric Ge­mehl

Euro­pean bank stocks have en­joyed a near 5% bounce in the last two trad­ing ses­sions of last week on hopes that the Euro­pean Cen­tral Bank will fol­low its Ja­panese coun­ter­part by ex­plic­itly adopt­ing poli­cies that help steepen the yield curve and so lessen the squeeze on bank lend­ing mar­gins. There are rea­sons to be more cheery about the out­look for Euro­pean fi­nan­cials, but a Ja­panese-style res­cue mis­sion may not be one of them.

Last Wed­nes­day, the Bank of Ja­pan re-com­mit­ted it­self to main­tain­ing mon­e­tary stim­u­lus un­til CPI ex­ceeds its 2% tar­get, while also an­chor­ing 10-year gov­ern­ment bond yields near zero, thereby fa­cil­i­tat­ing a curve steep­ing. Given that Ja­pan has been a lab­o­ra­tory for “creative” mon­e­tary poli­cies and the eu­ro­zone faces Ja­panese-style de­fla­tion­ary head­winds, a plau­si­ble ar­gu­ment can be made for the ECB to fol­low suit.

Af­ter all, the prob­lems that the BoJ’s new pol­icy frame­work seeks to ad­dress also ex­ist in the eu­ro­zone, namely, (i) a “dis-an­chor­ing” of in­fla­tion ex­pec­ta­tions, (ii) a scarcity of as­sets for the cen­tral bank to buy, and (iii) bank prof­its tak­ing a hit from neg­a­tive in­ter­est rates. More­over, the ECB last month tasked a com­mit­tee to as­sess the case for new as­set pur­chase op­tions.

The rea­son to think the ECB will not fol­low suit is that while the eu­ro­zone faces sim­i­lar broad chal­lenges to Ja­pan, the specifics of its sit­u­a­tion are sig­nif­i­cantly dif­fer­ent. Con­sider the fol­low­ing:

- While eu­ro­zone in­fla­tion­ary pres­sure sub­dued there are signs of it bot­tom­ing out.

re­mains

The ECB’s forecasts for HICP in­fla­tion—which have been steadily re­vised lower since quan­ti­ta­tive eas­ing was adopted early in 2015—have been sta­ble since March, and forecasts point to the mea­sure grad­u­ally ris­ing to­ward the ECB’s tar­get by late 2018. Also 5-year/5-year in­fla­tion swaps—which mea­sure ex­pec­ta­tions for in­fla­tion over a five year pe­riod start­ing in five years time—are trad­ing at a two month high.

- The ECB’s as­set scarcity prob­lem is not as acute as the BoJ’s.

Such a con­straint will only ma­te­ri­alise should the QE pro­gram, as we ex­pect, be ex­tended beyond its sched­uled ex­piry next March. As such, the ECB has time to play with. Also, any fur­ther up­ward rises in global bond yields will ex­tend the mo­ment when scarcity se­ri­ously kicks in, as bonds now yield­ing be­low -0.4% rise back above the thresh­old that make them el­i­gi­ble for ECB pur­chase.

- Prof­its at eu­ro­zone banks have been hit by neg­a­tive de­posit rates, but an off­set has come from a pick-up in lend­ing.

In ad­di­tion the ECB has been sup­port­ing banks through long term fund­ing based on neg­a­tive rates (TLTRO2). Banks can bor­row from the ECB at no cost and get paid if they in­crease lend­ing to the real econ­omy by spec­i­fied amounts. On Thurs­day, the re­sults of the sec­ond al­lot­ment from the TLTRO2 pro­gramme were an­nounced, show­ing EUR 36 bln be­ing taken up, com­pared to an ex­pected 22.8 bln. The im­pli­ca­tion is that eu­ro­zone banks want to cap­i­tal­ize on neg­a­tive rates and ex­pect to boost lend­ing.

An­other rea­son to think that the ECB will not fol­low the BoJ’s lead in di­rectly tar­get­ing the yield curve lies with con­cerns of “un­re­formed” mem­bers of the eu­ro­zone re­ceiv­ing di­rect “mon­e­tary fi­nanc­ing”. As the eu­ro­zone is made up of 19 dif­fer­ent sov­er­eign yield curves, such an ap­proach would re­quire sov­er­eign spreads to be elim­i­nated, which would nec­es­sar­ily in­volve the “cap­i­tal key” be­ing jet­ti­soned as the ba­sis for de­cid­ing how much of each coun­try’s bonds the ECB buys. This mech­a­nism was adopted in re­sponse to Ger­man con­cerns that a non-mech­a­nis­tic as­set buy­ing pro­gram would fa­cil­i­tate soft mon­e­tary fi­nanc­ing, largely flow­ing from north to south.

While Ger­many’s con­sti­tu­tional court soft­ened its stance on this is­sue ear­lier in the year, at the point that the sup­ply of bunds avail­able for the ECB to buy starts to dry up, it is un­likely that any­thing other than tar­geted and tem­po­rary bond-buy­ing de­vi­a­tions from lev­els dic­tated by the cap­i­tal key will be ac­cepted.

For this rea­son the re­cent eu­pho­ria among in­vestors in eu­ro­zone bank stocks looks a lit­tle over­done. There are rea­sons to be­lieve that a cycli­cal eu­ro­zone re­cov­ery and a less­en­ing of de­fla­tion­ary pres­sure will re­sus­ci­tate bank prof­its, but it will be a slow busi­ness and a Ja­panese-style quick fix is prob­a­bly not in the cards.

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