Market Overview

12 March 2020

The ECB Has Little Space to Manoeuvre Although Even Limited Actions May Impress Markets

The upcoming couple of weeks may re-draw the global investment roadmap with a potential short-term and long-term impact on the investment environment as the European Central Bank's (ECB) actions today and over next week may be slashed by half when the US Federal reserve (Fed) makes a further rate decision.


Most hedge funds and pension funds, as well as retail investors, are expected to go on with their plans for future purchases of super discounted shares after the present sharp downward correction will reverse. Apparently, in the periods of a new stock bloom market enthusiasts could prefer Wall Street traded assets, as usual, that may eventually lead again to growing capitalisation of US stock exchanges more than for the Europe-anchored companies. But this time in the pursuit of a safety cushion, at least for the part of their portfolios when it comes to European bonds, they may get more attention and even become a priority later on to mitigate risks of the entire portfolio.


The markets have priced a 10 basis point cut for the ECB deposit facility rate, which banks may use to make overnight deposits with the Eurosystem. It is now at the record low minus 0.50% though some policymakers warned that the central bank's overreaction could be counterproductive because it may hurt bank margins to the point of almost mute lending. Ultra-low interest rates also curb the very ability of the households to generate savings. That could hit consumer activity and even form pre-crisis sentiments. Finally, it turns out that the side effects of extra stimulating policy may put downward pressure on inflation, while the ECB's task is, on the contrary, to bring inflation to the higher levels, at around the 2% target. The actual Eurozone Consumer Price Index (CPI) was at 1.2% year-on-year in February 2020.


The ECB's Governing Council has restarted its asset purchase programme (APP) at a monthly pace of €20 billion in November 2019 "to run for as long as necessary to reinforce the accommodative impact of... policy rates, and to end shortly before it starts raising the key ECB interest rates." The ECB has added an extension of 120 billion Euros until the end of 2020 to the "targeted longer-term refinancing operations" (LTROs) designed to support bank lending to businesses and households on top of the 20 billion Euros currently. The ECB also said it would launch a new programme of cheap loans to banks to encourage them to keep lending to small businesses in order to withstand the economic consequences of the pandemic.


As for the widely expected mini-reduction of the ECB's Deposit rate by 0.1% or maybe even 0.3% the ECB decided to leave the rates unchanged.. This move, even if it is considered to be symbolic, could be vital in order for the ECB to legally extend its purchases within its mandate of some debt securities of those Eurozone countries where the coupon yield on bonds is now below the current level of ECB's Deposit rate at -0.5%. So it may be reserved for the future.


For example, the coupon yield of ten-year government bonds in France is now at -0.35%, but for the similar bonds in Germany the yield dropped below -0.8%, Belgium ten-year bonds are now traded at -0.3%, but the yield of five-years assets is -0.55%. The ECB according to the its internal rules can not include these securities in the APP. These restrictions prevent the European regulator from effectively injecting money into the financial systems of such countries, and to distribute money among the 27 EU countries in a justified manner.


At the same time, the US Fed's rate cut is not just symbolical. It has a real and very tangible effect. It has already urgently slashed the rate by 0.5 percentage points to 1.25% on March 3, and the market fully priced the future Fed's rate cut on March 18 by another 0.5 percentage points or even 0.75 points. Altogether, the cut is not only much larger in size but it is also an essential move for banks and for business, as loans become actually cheaper without derailing the banking system margins. What is most important for the financial market is that the Fed's actions do automatically entail less and less favourable conditions for the new American sovereign debt buyers and, on the other hand, it makes it cheaper for the US to service its huge 21 trillion debt.


Thus, the previously tremendous contrast between the monetary policies of the ECB and the Fed almost completely disappears. The ECB has been implementing almost the same ultra-soft policy since 2015, keeping the Euro on the very low levels against the US Dollar. There is no way to make the ECB policy softer. In contrast, the Fed has the ability to decrease its rates to near zero or even dive into the negative zone. But this path might not be paved with roses. Investors overstocked with US treasury bonds and therefore may be reluctant to buy new US bonds at an ultra-cheap interest rate and the US Treasury might not be able to attract as much money as it regularly does.


The US authorities cannot reduce an anxiety under the threat of the virus or for other reasons like trade wars. These alarm signals are now the main driving force for many investors to buy low-income government bonds in general and US Treasuries in particular. By trying to reduce the interest on loans for themselves in a pyramid-like model of public debt where the interest on old debts cannot be covered by incomes from the economy itself and instead are financed by new even more larger debt, the US financial system, at some point, could meet an unexpectedly opposite surprise for themselves. It may turn out that by trying to raise more money at zero percent for itself by lowering interest rates, the Fed could make a larger gift not to the U.S. Treasury, but to the European financial system. It is true that the markets will lend them money almost without any income for investors and without any serious expenses for the US Treasury, but the amount of this borrowed money may not be sufficient to pay interest on the previously borrowed US debt. This may also create a deficit of capital inflows with the resulting problems of covering the U.S. enormous budget deficit.


If the ECB will do everything in a proper manner, that is, if it offers the markets a message that the main incentives to the economy should be provided by state governments while the central bank has already created an extensive stimulus base, then more money flows could come to the Eurozone and to the Euro despite the US economic indicators are much stronger now. To get their hands on the European priority in financial investments, the ECB may talk about the overall strong position of the Eurozone economy prospects and, at the same time, focus on a growth-tailored monetary policy.


If the head of ECB Christine Lagarde does not "forget" today to remind others that ECB's measures are working well and there will be no major economic damage from the current coronavirus situation then EUR/USD could finally gain and may surpass not only the 1.15 level but it may also soar up to 1.20. This is, of course, only one of the possible scenarios. The first reaction after the introduction of new ECB stimulus may trigger the EUR/USD to roll back to even lower levels than it is now. The Eurozone position is now weaker because of a lockdown in Italy.


Another fresh source of weakness for the EU is that US president Donald Trump announced on Wednesday that the United States will suspend all travels from Europe, excluding the United Kingdom, to the United States for 30 days starting on Friday. However, Trump said trade will not be affected by the restrictions. He also announced some steps, including instructing the US Treasury Department to defer tax payments for entities hit by the virus. But the stock markets fell even to the lower levels after his speech. "For those who had been hoping for measures to offset likely fall in consumption, it was a disappointment," said Hirokazu Kabeya, chief global strategist at Daiwa Securities. "There was no talk of payroll tax cuts," he added.


The negative sentiment on the US and European stock exchanges creates many problems for investors. But after the decisions by the ECB today and the Fed on March 18, the bond holders will have more reasons to think carefully about which of the safe assets to choose from during this new situation, while also considering the ratio of a potential income and currency risks.


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