ECB: Another Important Rendez-vous in Frankfurt

• Economy shows signs of stabilization, but too early to call off downward risks
• Main policy rate to fall to 1% and remain there for a prolonged period of time
• Additional non-standard measures to optimize current 'enhanced credit support' via ...
• ... a lengthening of the refinancing operations and a commitment to keep rates low
• Executive board members sound still cautious about direct purchases of bonds

ECB rates approach bottom at 1%, what now?

At the May policy meeting, the ECB governing council is widely expected to cut the main policy rate again by 25 basis points to 1%, but to leave the deposit rate unchanged at 0.25%. Because this has been well signalled, because it is a relatively small change in the context of the 400 basis point decline already seen in the past eight months and because it is expected to be the final cut in the refinancing rate, it is not the main focus of attention for markets. Instead, investors are concentrating on what further action in the form of unconventional measures the governing council intends to announce at the press conference on Thursday.

Last month, the ECB governing council surprised friend and foe by cutting rates by only 25 basis points and delaying any announcement on unconventional measures to the May meeting. Although ECB governing council members haven't spoken in detail on the specific measures they may announce, recent comments from the executive board have emphasised that any additional non-standard action they take must reflect important structural differences between the financial systems of the Eurozone and the US. These differences make the ECB governing council wary of following the quantitative easing policy of the Federal Reserve (and the Bank of England). In particular, this makes the ECB seem very reluctant to embark on purchases of corporate and/or government bonds.

Instead, we expect the governing council will attempt to further improve their current 'enhanced credit support' framework. This is centred on the ECB's lending operations to the banking sector. This reflects the dominant role the banking sector has in the financing of the private sector in the euro zone which stands in contrast to the US, where capital markets play the pivotal role.

Since October of last year, the ECB has taken three important 'unconventional' steps to ensure that reductions in its key policy rates filter through to the real economy. First, the ECB has started to provide unlimited liquidity at a fixed rate at its main refinancing operations. Secondly, the operations have been extended to a maturity of up to six months. Thirdly, the collateral accepted in the operations has been broadened.

On the face of it these changes have been successful. There has been a marked decline in MFI interest rates on loans to both non-financial corporations as well as the household sector. According to a recent study by the Bundesbank, some 75- 80% of the ECB interest rate cuts have been filtering through into the bank lending rates, which is a typical reaction function. Along with the marked decline in the Euribor rates, this suggests that the monetary transmission mechanism in the Eurozone has isn't significantly impaired.

MFI interest rates on new loans to non-financial corporations with a maturity between 1 and 5 years decline sharply in response to the ECB interest rate cuts.

At the same time, it's still unclear how much the deleveraging of the financial sector is hampering the flow of credit to the 'real' economy. Lending growth slowed further in March, but compared to a year ago lending to non-financial corporations still increased by 6.3% Y/Y, while lending to households has stagnated but not fallen (at least so far). The big question is whether a slowing in lending of late is mainly due to (i) weak demand for credit, (ii) a typical cyclical tightening of credit standards or (iii) constrained supply of credit as a result of the credit crunch. In this context, the latest ECB bank lending surveys contains some hopeful signs, as it indicates that the tightening of credit standards has stabilized and that the decline in net demand for loans to enterprises and households is slowing. This can be interpreted as suggesting that there is no marked evidence of an economy-wide credit crunch in the euro zone at present. This is a very important conclusion, as such a credit crunch could still force the ECB's hand to intervene directly in the financial markets. Indeed, the success of the ECB's enhanced credit support is largely dependent on the willingness of the banking sector to lend to the private sector.

The reluctance of the ECB to embark into a direct quantitative easing policy and start buying assets also stems from concerns about potential problems that could arise as the ECB eventuality unwinds such measures. These were highlighted in a recent speech by executive board member Bini Smaghi, who pointed out that the reversibility of the unconventional measures will be an important factor to 'get the timing right in withdrawing additional liquidity in order to ensure a non-inflationary recovery'. 'Generally speaking, the lower the reversibility of the unconventional operations, the larger the risk of being behind the curve when the macroeconomic and financial market situation improves'.

The ECB's 'enhanced credit support' framework has a significant advantage in that much of the unwinding will happen automatically, 'since banks should naturally reduce their demand for central bank money and increase interbank lending as their situation normalizes'. It's therefore of the essence that the money markets work as normal to facilitate the eventual reversal of non-standard support mechanisms. 'In the euro area, the revitalisation of money markets is key to the ECB's exit strategy and any future interest rate decision should therefore avoid a further disruption of money markets'. These comments also suggest the ECB will want to keep the corridor between the main policy rate and the deposit rate as large as possible having made the mistake of narrowing the corridor earlier during the cycle. Therefore, we expect the 1% level to be the bottom of the easing cycle. 'In this context, bringing the main policy rate too close to zero would risk hampering the functioning of the money markets as it would reduce the incentives for interbank lending. This, in turn, could blur the important signals coming otherwise from the resurgence of interbank lending and the associated positive effect on the ECB's balance sheet'.

Bini Smaghi also points out that the reversibility of the unconventional operations may also vary with the maturity of the asset purchased. 'Obviously, the speed of tightening would also depend on the maturity of the assets bought by central banks within the framework of their easing programmes. Differences in the maturity of assets will ensure that a tightening of the accommodative stance would come in gradual tranches'. This argument highlights the difficulties potentially faced when buying longer-term assets. 'If market conditions were to improve faster than expected, an increase in the average maturity of the central bank's portfolio would make it more difficult for financial markets to return to normal private sector functioning and would also heighten medium-term inflation risks' Therefore, we still think that in the event that the ECB subsequently decides to purchase assets, commercial paper would be the most likely option. The short-term nature of these securities would not only facilitate an orderly unwinding but importantly it would also limit the credit risk to the ECB. This would in turn enable the ECB to support a broad range of companies and not just the large companies who have an access to the capital markets. Such an approach also appears more suitable as the corporate bond market for high investment grade companies has been one of the few bright spots within the financial markets, as with very strong issuance during the early months of this year.

Last but not least, the direct purchasing of assets also carries a huge risk that the ECB could suffer losses on these assets as Bini Smaghi concludes. 'An important final element related to the exit strategy ... is that when the central bank sells the assets their value is likely to have declined considerably, given the higher rate of interest. This implies a financial loss for the central bank. The consequences for the financial - and overall - independence of the central bank should not be downplayed'. The latter is ever more important for the ECB which is the central bank of 16 financially independent nations.

Besides this rationale, the relatively limited success of the purchases of government and/corporate bonds in the UK and the US is also likely to refrain the ECB from embarking into a quantitative easing policy at present. In both the UK and US, longer-term yields have reversed their initial decline on the announcement on the asset purchase programme. Last week, both US 10- and 30- year yields even broke above the recent highs and stand currently at their highest level since last November. Most of the increase in nominal yields is due to higher inflation expectations, which suggests that the longer-term inflationary risks stemming from the purchases shouldn't be downplayed. This will further strengthen concerns at the ECB for which ensuring price stability has always been the guiding principle. Hence, instead of buying longer-term government and/or corporate bonds, we expect the governing council to provide some kind of commitment that policy rates will remain low for a prolonged period of time, like the Swedish Riksbank and the Bank of Canada have done recently, in order to keep also longerterm yields at a rather low level. Such a commitment would pose less of risk with regard to their price stability credibility.

US 10-year yields reverse initial decline on Fed announcement of Treasury purchases and did even break higher last week when the Fed didn't raise the amount of the purchases.

Whether a lengthening of the refinancing operations combined with a commitment to keep rates low for a given period of time will be sufficient to keep longerterm yields low remains to be seen. In both Canada and in Sweden, longer-term yields have continued to trend upwards afterwards in line with the rising trend on the global bond markets. The break higher in longer-term US yields suggests that the balance of risks for longer-term yields has shifted from the downside towards the upside. As such, we would no longer prefer to go long bonds in the event of upward corrections in yields, but instead prefer short positions when yields approach the recent lows at around 3% in German 10-year yields.

German 10-year yields still within recent sideways range, but has the balance of risks shifted from the downside to the upside?

Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.