1. What is the ECB going to do? The ECB is widely expected to announce that it will accelerate and broaden its efforts to expand its balance sheet.
2. How will it do this? The ECB is currently buying two types of assets: covered bonds and ABS. Covered bonds are bank-issued bonds frequently backed by a pool of mortgages. The bank retains some of those exposures on its balance sheet rather than selling all of it to other investors. It is also buying asset-backed securities; mostly consumer and small business loans packaged by banks. In addition, the ECB is expanding its balance sheet by granting more low interest rate loans to banks under a program called Targeted Long-Term Repo Operations (TLTRO). However, an older lending program is expiring (LTRO), and as banks repay these funds, it reduces the ECB's balance sheet. As deflationary pressures strengthen, and growth continues to be revised down (ECB in December, World Bank and IMF this month), the ECB wants to expand its balance sheet more aggressively. It is widely expected that the ECB will announce a plan to buy sovereign bonds.
3. Is this quantitative easing? There is no agreed upon definition of quantitative easing or QE. The Federal Reserve did not refer to its Treasury and Agency purchases as QE, but rather called it credit easing. To the extent that QE has a meaning, it refers to a monetary policy aimed at increasing the size (quantity) of a central bank's balance sheet. In addition to sovereign bonds, the Bank of Japan buys corporate bonds, commercial paper, ETFs, and REITs. The ECB will widen the range of assets it buys to include sovereign bonds. It may also buy the super-nationals, such as the EU and European Investment Bank bond, and possibly the bonds issued to provide support to a number of peripheral countries. Arguably, it should be willing to buy any asset it accepts as collateral.
4. Given the slow growth of the eurozone and outright negative inflation print, why does this seem so controversial? Although the decision to buy sovereign bonds will be supported by a clear majority, it will not be unanimous. There are at least three sets of objections. The first is legal. The ECB mandate bans it from monetizing sovereign debt. The same group of Germans who challenged the legality of an earlier ECB program (Outright Market Transactions or OMT) will likely challenge the legality of sovereign bond purchases. A second set of objections involves moral hazard. The monetary assistance reduces the pressure for structural reforms. A third set of objections is on efficacy grounds. European interest rates are already at or near record lows. Seven eurozone members have negative two-year yields. Four members have 5-year yields below 10 bp, and this does not count Germany where the 5-year yield is below zero. A derivative of this argument is that what ails the euro area cannot be addressed by monetary policy. Some argue the problem is a massive debt overhang, the lack of structural reforms, and insufficient aggregate demand.
5. How large of a program should we expect? In order to forge a consensus and minimize the risk of political pressure from creditor nations, especially Germany, there were likely several important compromises that may have been worked out. One of the key compromises is the size of the buying program. The ECB has reached an agreement that the balance sheet should grow by about 1-1.2 trillion euros. It will achieve some of that by its current TLTRO and asset purchases. In fairness, the asset purchases and TLTRO have been on the low side. They may conservatively be expected to help expand the balance sheet by 400-500 bln euros by the end of this year. This is why the consensus is for the ECB to buy around 500-700 bln euros. The ECB may not announce such a figure. Instead, it could opt for a monthly figure, say something 40-50 bln a month to be reviewed before the end of the year.
6. If the amount of bond purchases is one compromise, what are the other compromises? A key issue is who bears the risk of the bond purchases. Under the conditions of a complete monetary union, one would naturally expect the risks to be pooled. The concept here is jointly and severally, meaning that all countries bear the risk in proportion to its 'capital key' (share of the ECB that is a largely a function of the size of the economy). Having the national central banks buy and hold their own bonds is a way to minimize the risk to the ECB and the creditor central banks, like the Bundesbank. On the other hand, it would provide evidence of the incompleteness (and therefore less ostensibly less credible) of European monetary union. One possibility is that the program calls for both elements. The ECB buys some sovereign bonds, and national banks buy some as well. The problem with this course is that it is more complex and requires greater coordination.
7. Are there other compromises? Another area of compromise could relate to which bonds are purchased. There may be some agreement against buying government bonds with negative yields and/or maturity specifications. A prohibition against buying negative yielding instruments will force several countries to move further out on the curve, toward longer-dated maturities. Yet, a preference for shorter-dated instruments is a way to minimize the risk. The creditors may prefer buying only the highest quality bonds, but this risk widening out the spreads between Germany and others, and could be destabilizing.
8. Assuming that the broad outlines sketched here are fairly accurate, how do the markets respond? Part of the reasons European bond yields fell, shares rallied and the euro slid was in anticipation that the ECB would take stronger actions. ECB President Draghi has telegraphed his intentions. The media have been full of the he-said/she-said stories, with leaks and counter-leaks. There is some speculation that the ECB will also cut its deposit rate that is currently set at -20 bp and/or the lending rate, that stands at 30 bp. On the premise that investors respond more to surprise than as expected developments, we have warned not to expect a simple "ECB does QE, euro sells off". That said, there are many moving pieces, one should be prepared for a volatile session. Aside from the near-term volatility and position-adjustment, we still look for the euro to trend lower. We envision this trend will carry the euro below $1.00 next year.
9. What is your outlook for the eurozone economy? As part of the IMF's update to its World Economic Outlook it shaved about 0.2% off its forecast for eurozone growth this year and next to 1.2% and 1.4% respectively. Measured by the headline consumer price index, deflationary forces will likely intensify in the coming months. Excluding food and energy, however, the eurozone is not experiencing deflation. Core inflation was 0.7% year-over-year each month of Q4 14 and remained there in the preliminary estimate for January.
10. What role are the Greek elections playing in these decisions? The failure of the Greek parliament to pick a new president has forced national elections. The election is January 25. The left coalition called Syriza has been consistently 2-4 percentage points ahead of the Prime Minister's New Democracy Party. Syriza promises hard negotiations with Greece's official creditors (IMF, EU and ECB). It also wants to roll back large parts of the austerity that was imposed, and which now is beginning to show some fruits (positive growth, easing unemployment, a primary budget surplus). The party with the most votes is given 50 extra-bonus seats in the 300 seat parliament in hope of forming stronger governments. Even with these, it is not clear Syriza will be able to survive a vote of confidence. If it has a plurality of votes, it will be given the first chance to secure a majority in parliament. If it fails, the party with the second most votes is given a chance. If that fails, the third most popular party gets an opportunity. Each has no more than three days to be able to survive a vote of confidence. If all fail, new elections will be held in short-order. This is what happened in 2012.
11. Will Greece leave the monetary union? There is heightened fear that a Syriza victory will lead to Greece leaving EMU. While this is possible, we continue to regard it as unlikely. There is plenty of room for compromise. It has long been signaled that after completing the assistance programs, there was room for the official creditors to reduce the interest rates and lengthen maturities to ease Greece's debt burden. The current assistance program expires at the end of next month. If a new one is not in place, the ECB has indicated that it no longer could accept Greek sovereign bonds as collateral. About 2/3 of Greek banks' 40 bln euro borrowings from the ECB use government bonds as collateral. Those funds would need to be replaced. The Greek central bank can only provide emergency funding (ELA) with the ECB's permission. At least a couple of Greek banks have applied for ELA funding now, and the ECB is likely to authorize it. Without an assistance program in place, it may be more difficult to secure ECB approval. The political uncertainty in Greece is unlikely to play a significant role in the shape of the ECB's bond buying program. A decision not to buy below investment grade bonds would impact not only Greece, but also Portugal, Cyprus, and Slovakia.
Related:
Markets Pricing in Substantial QE Operation by the ECB
