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PIMCO: ECB Preview – Lift-off

By Konstantin Veit, Portfolio Manager at PIMCO

After having ended net asset purchases in June, the ECB will likely hike interest rates next Thursday, the first rate hikes in the Euro area since 2011.

We believe the ECB will hike its policy rates by 25 basis points, signal a 50 basis point increase for September and communicate that further increases in interest rates will likely be appropriate.

The ECB is also expected to unveil the contours of its new anti-fragmentation backstop. We believe the ECB will essentially settle for an Outright Monetary Transactions (OMT)-type facility that allows for interventions in sovereign debt markets in case the Governing Council (GC) establishes that the monetary policy transmission mechanism is impaired. We expect somewhat less onerous conditionality than under the OMT, and purchases to be sterilized so as not to interfere with the overall monetary policy stance.

Investment implications:  While the ECB will aim for a smooth normalisation of monetary policy, the macroeconomic configuration remains complex and central bank communication challenges elevated. 

Additional thoughts:  

Interest rates

At its June monetary policy meeting the ECB was guiding towards an initial 25 basis point rate hike in July, followed by a potentially larger hike in September, which would end eight years of negative policy rates in the Euro area. The June Meeting Minutes suggest that the more hawkish GC members essentially succeeded in locking in a 50 basis point hike in September in exchange for 25 basis points in July. Beyond September, the GC judged “that a gradual but sustained path of further increases in interest rates will be appropriate”.

The market is pricing around 160 basis point of rate hikes by the end of this year, essentially 25 basis point hikes in July and December, 50 basis point hikes in September and October with some risk of a more aggressive pace. There remains considerable uncertainty where a neutral policy rate for the Euro area might be, but anything meaningfully above 1% in nominal terms seems somewhat less plausible in comparison to other developed market jurisdictions, such as the UK or US.

Current market pricing of a 175 basis point interest rate cycle hence suggests broadly neutral territory for the ECB, with a peak policy rate of 1.25% in early 2023. A 175 basis point cycle would be marginally below the two previous, pre-global financial crisis ECB hiking cycles, and while we do not believe the ECB will provide a lot of guidance regarding the potential destination of interest rates at this stage, we think the GC will make clear that a gradual approach might not be appropriate in all conditions, particularly if faced with high spot inflation threatening to de-anchor medium-term inflation expectations.

A GC majority probably still favours the concept of gradually normalizing policy, but further upside surprises on inflation might swing the pendulum towards more aggressive moves on policy rates, and could solicit discussions around balance sheet normalization. We think the ECB will increase all its interest rates by the same amount, keeping the policy rate corridor between the deposit facility rate and the main refinancing rate unchanged, as a tightening of that corridor would reduce the incentive scheme embedded in the targeted long term refinancing operations (TLTRO) and discourage money market activity more broadly.

Nevertheless, in a context of abundant excess reserves the deposit facility rate remains the sole reference rate for money markets, a situation likely to continue given the sheer amount of excess liquidity in the system and lack of any active balance sheet run-off plans. A passive run-off of the TLTROs would see the ECB balance sheet shrink by around 25% over the next 2.5 years, without pushing excess liquidity below the threshold required to keep money market rates anchored around the deposit facility rate.

 Anti-fragmentation-tool

While legal considerations are relevant, political challenges constitute probably the main hurdle for a facility with country spread caps close to the money. Fragmentation is essentially a political issue and, as a result, there is a wide range of views as to what extent fragmentation should be dealt with by the central bank instead of elected government officials.

President Lagarde will aim for GC unanimity, which inevitably entails compromise. The new anti-fragmentation tool will likely be a backstop facility in nature, not a regular purchase programme. We believe the ECB will essentially settle for an OMT-style tool that allows for interventions in sovereign debt markets in case the ECB establishes that the monetary policy transmission mechanism is impaired, a judgement likely linked to “unwarranted” developments in peripheral spreads. The important question will be what framework the ECB decides to use to make that judgement, and what the conditionality requirements will look like.

Rapidly widening spreads can typically not be credibly explained by macroeconomic fundamentals, which tend to be slow moving. And while the speed of spread moves might at times provide a somewhat less controversial basis for intervention, a slow grind wider in spreads or unfavorable moves on the back of domestic political events are less straightforward to address. We do not see the ECB disseminating a lot of details on the decision making process, and we certainly do not expect the ECB to communicate spread caps or fair value estimates of country spreads.

While the ECB will impose conditionality for interventions under the new tool, we believe that conditionality requirement will be somewhat less strict than under the OMT, and could be linked to some form of compliance with the current NextGenerationEU (NGEU) facility. All Euro area member states have taken NGEU grants, which will pay out until 2026 on the basis of satisfying the quantitative targets and qualitative milestones laid out in the approved National Resilience and Recovery Plans (NRRP). The ECB is also likely to announce the intention to sterilize any purchases made under the new facility, with the most likely option the issuance of 1-week term deposits to banks, as has been standard practice under the Securities Market Program (SMP).

 TLTROs

The ECB announced the special pandemic conditions applicable under TLTRO III to end in June. While earlier in the year the anticipated expiry of the 50 basis point subsidy led to expectations for potentially sizeable early TLTRO repayments, the aggressive repricing of ECB policy rates has subsequently changed the calculus for banks. Given the rate applied to TLTRO borrowing post-June 2022 features the average deposit facility rate during the entire life of the operation, banks still have a carry incentive to maintain their TLTRO liquidity as the borrowing rate would be lower than the rate applied to central banks deposits in the event of rate hikes.

That has led to discussions on whether the ECB would change the terms of the TLTROs to prevent banks benefiting from arbitrage beyond the pandemic period. Since introducing TLTROs in September 2014, the ECB has changed terms and conditions several times. However, all changes made terms more favourable than the initial design of the operation, and in some cases were applied retrospectively. We believe the ECB could choose to set the TLTRO rate equal to the average deposit facility rate during the remaining life of the operation after the conclusion of the special period in June. This would make the cost of borrowing equal to the average deposit facility rate, thus eliminating any form of arbitrage in keeping the TLTRO liquidity. Other, less aggressive forms of arbitrage mitigation might also be under consideration, such as via charging an additional spread or an adjustment to the tiering system. Out of the €2.1trn TLTROs outstanding, we think that borrowing for arbitrage amounts to around half of that amount, with the rest borrowed for funding.

However large the early repayments eventually, we believe they will not cause any material tightening in liquidity conditions as long as they are largely limited to the amount of borrowing taken to arbitrage the deposit facility rate, as these funds have been sitting idle at the various national central banks and never circulated in money markets. Hence we do not expect TLTRO repayments to materially impact the euro short-term rate (€STR), as unsecured overnight deposits from financial institutions without access to the ECB deposit facility should be largely unaffected by such a decline in bank reserves. Similarly, pressure on Euribor fixings would predominantly result from banks replacing central bank funding with unsecured market funding.

TLTRO repayments will likely free up some collateral though, including government bonds taken out of the collateral pool at the national central banks and made available to the broader repo market. Hence we might see some modest cheapening pressure on repo rates in case of large TLTRO repayments, but nothing major as we also foresee demand for high quality collateral to remain solid.

Tiering framework 

The two-tier system, which exempts part of credit institutions’ excess liquidity holdings from negative remuneration at the rate applicable on the deposit facility, has been in operation since late 2019. Currently, six times the institution’s minimum reserve requirements are remunerated at 0%, the same multiplier since inception of tiering despite much higher levels of excess liquidity.

With non-negative policy rates coming into sharper relief, an unchanged tiering configuration instead of a late change to the multiplier seems like a reasonable base case, with the ECB simply abolishing the framework altogether at the September meeting. Once negative policy rates have been left behind, we believe the ECB is unlikely to revisit such a policy again in the future and rather accommodates via net asset purchases, favorable liquidity provisions to banks and various forms of forward guidance.

 

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