€2.6 trillion insufficient gift - Andrew Borg
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€2.6 trillion insufficient gift - Andrew Borg

In a press conference held earlier this month, the President of the European Central Bank, Mario Draghi, unveiled a significant change in the European Central Bank’s economic outlook for the eurozone. Draghi said that the bloc’s economic growth is experiencing a slowdown, and consequently the ECB has to amend its monetary policy accordingly.

The change to a more dovish tone, which is in line with the American Federal Reserve’s decision to temporarily pause rate hikes, is based on weak economic data. This data ultimately led to a revision of the ECB’s annual GDP growth forecast, from the previous 1.7 per cent to a 1.1 per cent for 2019.

As a result, the ECB has decided to ease its monetary stance in a bid to stimulate the economy once more. This conflicts with ECB’s direction in 2018, during which it seemed to tighten its monetary policy, after years of monetary stimulus. 

This can be quite alarming when one considers the fact that the ECB had been practically handing money to banks for years now, through its expansionary monetary policy. However, it seems that not even this multi-trillion dollar ‘gift’ by the ECB was enough to resuscitate the economy. 

To take this into context, let’s go back to 2012. The eurozone was hit by the second recession in three years, partly as a result of the austerity policies which had been put in place to combat the effects of the credit crisis. 

In March of 2015, as part of the recovery from the 2012 recession, the European Central Bank started a drastic asset purchasing programme for the first time in its history, also known as Quantitative Easing. In simple terms, through this programme, the ECB would be buying sovereign and corporate bonds, therefore pushing the prices upwards and creating money in the banking system. As a consequence of this increased liquidity, interest rates fall and loans become cheaper, thus encouraging more borrowing, and boosting consumption and investment.

In December 2018, the ECB issued a widely anticipated announcement that the bond-buying programme shall be coming to a close. During the four years of the programme, the ECB had pumped a massive €2.6 trillion in the eurozone in an effort to revive the bloc’s economy. 

In view of all this, this month’s announcement of new stimulus was somewhat surprising, as it comes just months after the conclusion of the massive asset-purchase programme. 

The ECB had previously stated that interest rates shall remain at their present record low levels through the summer but it has gone on to rule out a rate hike, at least through the end of 2019. This has confirmed that Draghi, whose term as President ends in October, will see out his tenure without ever having raised interest rates, since the last rate hike in the eurozone was back in April 2011, two months before Draghi was appointed President. 

Additionally, the ECB has launched a new series of Targeted Longer-Term Refinancing Operations (TLTRO-III) effective on September. In simpler terms, the ECB has offered banks a new round of cheap loans. The aim of this funding is to reduce the burden on banks to avoid a credit squeeze. This means that around €720 billion worth of debt from the first series of TLTRO, which are approaching maturity, will now be eligible to be rolled over.

Draghi attributed the weak economic performance to geo-political factors, including international trade concerns, uncertainty over Brexit and weakness in emerging markets. Some even argue that the ECB’s downgraded growth forecast is still too optimistic, and that the ECB might actually have to restart the asset-purchasing programme.

In our current climate of geo-political uncertainty, there is only so much the ECB can do. On such matters, it is up to the European Commission and the countries’ governments to sort out these issues, which have been the source of volatility in financial markets and fear among investors.

This month’s announcement of new stimulus was somewhat surprising

Even in this regard, however, choosing the appropriate measure is no straightforward task, since after years of stimulus, the tools at the ECB’s disposal are becoming increasingly limited. For example, when trying to provide cheaper funding to banks, the fact that the interest rates are already so low might render such a policy ineffective.

Considering the path which the ECB had seemed to be following, the recent change in rhetoric was a surprise for the markets. In the aftermath of the announcement, the euro dropped about 0.7 per cent against the US dollar. 

As expected, German bund yields drifted lower, even though they were already close to zero, as investors lowered their expectations of higher yields any time soon. For example, the German 10-year yields fell by one basis point to the lowest level since October 2016, to 0.06 per cent. Italian bonds prices also rose on the announcement of the new option for cheap funding. Banking stocks had an interesting reaction to the news as they initially posted gains, before trading lower once it became clear that the terms of the new loan might be less favourable than the original ones.

With regards to sovereign debt instruments, Malta was no exception, as the recently launched MSE Malta Government Stocks Total Return Index was up 0.57 per cent in two days, following the press conference.

The reaction of the local corporate bonds was less clear, if there was even a reaction at all. The MSE Malta Corporate Bonds Total Return Index climbed 0.2 per cent the day after the announcement, before fully erasing the gain within three days.

An alternate view on the revised ECB monetary policy is that it is not a U-turn on the previous direction, but rather a transitional phase in the same direction. Some economists are arguing that if the idea of the new ECB policies was to generate extra stimulus, these measures are insufficient. This is mainly due to the fact that the new lending to banks will be on less generous terms than in the past years.

For starters, new loans will have a term to maturity of two years, compared to the previous loan periods of four years. Furthermore, the rate of this debt will be indexed to the ECB’s main refinancing rate, which is currently set at zero. Previously, the loans could have been as low as the deposit rate, which is currently in negative territory. 

Another interesting decision is that this programme shall start in September, meaning that certain restrictions of the programme will exclude around €400 billion worth of loans from having the possibility of being rolled over by using the TLTRO-III programme. 

In light of this, the move might indicate that the actual motivation behind these policy decisions is, in fact, to slowly reduce the dependence of the banking system on the ECB. Investors who take this view might perceive this month’s press conference as a smaller-than-expected step in the same direction, rather than a complete step back on the ECB’s original path to recovery.

This article was prepared by Andrew Borg, B.Com (Hons) Banking and Finance (Melit.), trader at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on 2122 4410, or e-mail andrew.borg@jesmondmizzi.com. 

www.jesmondmizzi.com

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