ECB May Buy Bonds - Going Further Than Expected

The ECB reduced its main refinancing rate by 25 bps to 1%, narrowing the corridors to 75 bps on both sides as the deposit rate remained unchanged at 0.25% while the marginal lending rate was lowered by 50 bps to 1.75%. While President Trichet stated that the current key ECB interest rates are 'appropriate', he refused to confirm the new rate level is the floor.

After cutting the policy rate by 325 bps since October, 2008, the central bank also announced some 'non-standard' measures at the press conference today. First, the ECB extended the maturity of the longer-term refinancing operations to 12 months. The operations will be conducted as fixed rate tender procedures with full allotment and the first operation will be announced on June 23. Subsequently, the fixed rate may include a premium to the rate on the main refinancing operations, depending on the circumstances at the time. Moreover, the loosening of collateral requirement will be extended to end-2010. These were widely anticipated by the market as the measure should have aroused less debate among members than the others.

Second, the ECB has decided 'in principle' that the euro system will purchase around 60B euro of covered bonds denominated in euro and issued the euro area. Details will be announced after the Governing Council meeting on June 4. This move came in earlier than we expected. Trichet stated that this is not a QE policy and the aim of the purchase is to help the covered bond market to function better rather than to provide additional liquidity to the economy. Therefore, we tend to believe that, at least in the beginning, the purchase will be sterilized – no printing of new money.

So how big is 60B euro in the system? Although the amount was not big for the overall economy (3% of the Eurosystem's current balance sheet and less than 1% of 2009 nominal GDP in the Eurozone), it's quite significant within the spectrum of covered bond market. 60B euro represents 10% of the 600B euro jumbo covered bond market with each of Germany and Spain accounting for around 250B euro of it.

Moreover, the European Investment Bank will become an eligible counterparty in the Eurosystem's monetary policy operations with effect from 8 July 2009 and under the same conditions as any other counterparty. The European Investment Bank can access to the Eurosystem's liquidity and provide loans and guarantees. This is also another unexpected but nice approach as small and mid-sized companies which might have difficulties in accessing loans during crisis will find it particularly helpful.

Concerning the June Staff Projection, Trichet mentioned that it would be "very likely in line with the most recent projections published in particular by European Commission and IMF". In its April report, IMF estimated GDP growth in the Eurozone will be -4.2% and -0.4% in 2009 and 2010 respectively while consumer price will ease to 0.4% and 0.6% in the 2 years. The European Commission also forecast that the Eurozone economy will contract by -4% in 2009 followed a decline of -0.1% in 2010. Also, HICP inflation will come in at 0.5% and 1.25% in 2009 and 2010 respectively.