Will Draghi Deliver? (and will it matter?)

Long time readers of this space may recall that the prior president of the ECB, a certain Jean-Claude Trichet, was something of a bete noir for your author.  By consistently delivering the wrong policies at the wrong time, with his own inimitable brand of smugness, Trichet provided punters with both a source of derision on the first Thursday of every month and a skein of policy errors to trade against.

His successor has proven a little more savvy.   Mario Draghi earned the sobriquet "Super Mario" for his performances over the first year of his tenure, with his decisive policy shifts to counter both the liquidity shortfall and the deflationary impulse confronting the Eurozone financial system.    His coup de grace, of course, was the announcement of the OMT, a veritable Schrodinger's cat of a monetary policy so effective that it's never seen the light of day.

Since saving the world (or at least the Eurozone) in 2012, however, both his duties and his performance have been somewhat more mundane.   The sovereign crisis and the fiscal austerity that it imposed on large swathes of Europe have left many of the non-Teutonic economies gasping for air, which is admittedly a poor hand to be dealt.  Sluggish growth and strong disinflation have kept the ECB on an easing track, yet in contrast to his 2011-12 performance, Draghi has often seemed reactive and over-reliant on relatively upbeat forecasts.

Now some of this may no doubt be the result of pressures applied by the Germanic contingent upon the ECB, who have both called for a deflationary fiscal policy and then complained whenever a monetary offset has been in the offing.  The still-in-limbo legal fate of the OMT may also have stayed the ECB's hand when the contemplation of more unorthodox measures arises.

All that having been said, even with a relatively narrow range of instruments at his disposal, Draghi has been more Wario than Super Mario recently.   For all the chitchat of a negative deposit rate over the past fifteen months, we're still waiting.   The ECB's version of forward guidance has been generally lame, serving more as a descriptor of an identical reaction function than the unveiling of a new, more dovish one.  Meanwhile, the inflation rate moves further and further away from 2%.....

What's been particularly irritating for many observers (and no doubt more than a few punters) is that Draghi seems to have gone out of his way to pooh-pooh the notion of a deflationary impulse in Europe or the need to address it.  Indeed, when last month's press conference unveiled a lower-than-expected inflation forecast for 2016, Draghi made sure to point out that the y/y forecast for December of that year was quite a bit closer to 2% than the year-as-a-whole forecast.

Similarly, when queried about the decline in excess liquidity and the concomitant rise in Eonia at the first meeting of 2014, Signor Draghi engaged in a misleading song-and-dance routine that was more suitable for La Scala than a Frankfurt briefing room.  Unsurprisingly, the liquidity situation has not improved, and Eonia has continued to push higher, setting at 0.212% yesterday.   The one-week average, admittedly impacted by quarter end, recently set at its highest level since January 2012, when the refi was 1%!

Many readers will no doubt be familiar with the liquidity convexity story, in which the spread between Eonia and the ECB deposit rate is a function of the amount of excess liquidity in the Eurosystem.   As the scatter plot below illustrates, the current level of excess liquidity (EUR 118 billion) is right at the level where the spread to the depo rate (currently 0%, of course)  "kinks" to the right.

So there is certainly a school of thought that the ECB will be forced to do something to mitigate this kink- either by lowering the deposit rate to negative territory (which would then drag Eonia lower), or by eliminating the sterilization of the Securities Market Programme, which would then increase the amount of excess liquidity in the system and push the spread back down.  Indeed, many observers, including your author, assumed that non-sterlilization was going to happen in March, particularly after the German contingent apparently granted its public blessing.   If we take Draghi's press conference at face value, however, the sterilization issue evidently received as much attention during the meeting as which wine to order with the second lunch course.

However, even if the ECB were to quit the systematic sterilization of the SMP, it is not altogether clear what the impact would be.   The scatter plot above, for example, does take into account the width of the ECB corridor (i.e., the spread between the deposit rate, the refi rate, and the marginal lending rate.)  The refi/depo spread, currently 0.25%, was 0.75% for much of the observation period, thus allowing more latitude for Eonia to rise.   Now, with such a narrow corridor, in normal circumstances ECB sterilization operations should begin to fail if Eonia were to trade above 0.25% (i.e., why lend money to the ECB at the refi/MRO rate when you can lend it in the Eonia market at a higher rate?)  Thus, the system should to some extent be self-correcting.

This issue becomes evident if we look at the depo/Eonia spread not in nominal terms but as a percentage of the corridor.   For example, if Eonia were to set at 12.5 bps, it would be 50% of the way through the corridor.   At 5 bps, that ratio would be at 20%.  Currently, Eonia is setting 85% of the way through the corridor, suggesting that the pain of the excess liquidity shortfall has already largely been felt in the market.   (In case you were wondering, that number was at 65% at the time of the last ECB meeting.)

Of course, an argument can be made that the ECB should do everything it can, including driving the Eonia rate back to the lowest level possible, to fight the disinflation/deflation currently gripping the Eurozone.   However, despite all the brave words from a number of ECB talking heads recently, it is not altogether evident that such a move would pass a cost-benefit analysis test.

For one thing, to target the level of excess reserves in the system would quite literally be QE- namely, a targeting a quantity of money.   Non-sterilization of prior bond purchases would also sail perilously close to the rocky shore of monetary financing, and Draghi's bluff dismissal of the issue when queried might belie a desire to get the OMT court case out of the way before pursuing this option.   Meanwhile, it is not clear that 10 or 20 bps in Eonia is going to make a hill of beans' difference to credit creation in Europe, where the AQR is dominating banks' behaviour.  This is especially the case given that 1y1y Eonia is still very well behaved at 0.25%.  Finally, there is little empirical evidence that uber-low interest rates are effective in reining in undesirably low inflation.

Five years in, it hasn't worked in the US.   It hasn't worked in Switzerland.   For the better part of a dozen years it didn't work in Japan, until Abenomics torched the currency.  Ah, the currency!  If the ECB were to engage in some sort of QE or negative deposit rate experiment, that could perhaps spur a downmove in the euro that would no doubt be welcome throughout the Eurozone.

While any action from the ECB today will no doubt send the euro juddering lower, it is from from clear to Macro Man that it will have any lasting impact.   Indeed, the effect of interest rate differentials as an exchange rate determinant has waned considerably over the last year, as the below chart of EUR/USD and the euro/US 1y1y spread indicates.

Macro Man isn't too proud to admit that he has not fully grasped the reasons for the wedge between the two.   Part of it is no doubt the easing of the sovereign worries in Europe, which would be a wonderful explanation had the euro bothered to meaningfully decline when its future appeared in doubt.   The 'Japanification' theme offers some resonance, but it still seems of that the link has completely broken at more or less the exact point that the US short end began to meaningfully reprice.  Perhaps it's Macro Man's old mates at PBOC, given that they have amped up the reserve accumulation recently?

Sigh.  It would be fun to know what the macro market's aggregate P/L in EUR/USD for the past several years would look like.   Macro Man would hazard a guess that it's not pretty, as he's fairly sure that he's not the only one that's been left bemused by the price action over the last several years.  As such, despite the low inflation print Macro Man is not totally convicted that the ECB will do anything....and even less convinced that it will matter.
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abee crombie
April 3, 2014 at 1:26 PM ×

Well as bad a Tichet was, can you imagine if we still had Weber in the loop ;-)

And what about uncle Duisenberg, I hear he was a bag of fun as well.

I think you hit it on the last point, what can super mario really do here. Peripheral rates already coming down, short and long rates low historically and not much concrete evidence that making them lower does much for growth. I think ECB's focus is more with the banks/AQRs and hopefully a clean up of that will transfer assets from good to bad (many PE still waiting for banks to take the needed bath, write off the loans and then sell em) and then hopefully credit channel clears.

Digging deeper, loans are created when there is demand, and as Japan has seen, while its easy to manufacture widgets, you cant manufacture demand (unless you are US, Brazil, India etc ). Cyclically there is probably still some room left for Europe to bounce back (inventory rebuild, replacement cycle) but secularly it has a really big problem esp with surplus countries like Germany

Congrats bro abee crombie you got PERTAMAX...! hehehehe...