When Mario Draghi unveiled the European Central Bank’s latest stimulus package earlier this month, the restarting of quantitative easing with €20bn per month of government bond purchases took most of the headlines.
However, in the weeks since it has become clear to us that market participants are underestimating the impact of another measure announced on September 12, namely the ‘tiering’ of bank deposits to alleviate the negative rate burden on a substantial portion of banks’ assets.
By our calculations, the introduction of tiering on October 31 – incidentally Draghi’s last day as president – will lift around €750bn of banking sector assets out of the ECB’s new -50bps deposit rate and up to zero. What markets perhaps haven’t fully appreciated is the unintended tightening of Eurozone financial conditions this is likely to cause.
Negative rates have been one of the biggest factors behind the recent squeeze on government bond yields, particularly at the short end of the curve as bank treasurers have looked for a more efficient way to deploy the cash reserves they have been charged to hold at the ECB.
When re-evaluating their holdings as tiering approaches, those same bank treasurers will be less likely to hold short term government bonds, which would see yields on those bonds rise; a tightening of financial conditions that Draghi and his fellow ‘doves’ on the governing council could do without.
We wrote about this tiering tightening and the inevitable need for QE to combat it in advance of the September 12 meeting. Now we know the details of the tiering scheme, and the exact volume of QE the ECB will be doing, we don’t think it will be enough. Before long, we expect Draghi’s replacement Christine Lagarde will need to convince the governing council to do more.
Lagarde was seen as a dove at the International Monetary Fund, and her appointment was broadly welcomed by market participants in July, but only time will tell whether she possesses the kind of political nous that has enabled Draghi to enact a range of extraordinary measures over the course of his tenure.
In our view, Draghi will have known that €20bn of government bond purchases wasn’t the end-game for this stimulus package. As he has done on previous occasions, he is taking the governing council on a journey towards the level of easing he believes is required. With the surprise resignation on Wednesday of Sabine Lautenschläger, the most senior German member of the governing council and a fierce opponent of restarting QE, that journey may be smoother than he first thought.
With the German economy on the brink of recession, the outcome of Brexit uncertain and the lingering prospect of Donald Trump’s trade tactics returning to Europe, this could be a critical period for the Eurozone economy. In the wake of the September 12 meeting the ECB’s chief economist, Philip Lane, said tiering had been calibrated to strike the right balance between offsetting the cost of negative rates for banks, while allowing the accommodative policy stance to filter through and boost inflation, emphasising that it could be adjusted if the impact wasn’t as intended. Lane added that he was looking forward to working with Lagarde, who starts work on November 1, and that the ECB president and chief economist “will always have a close working relationship”.
For those hoping the taps will be opened wider, that relationship could be a crucial one. Draghi has set the governing council on a journey, but it will be up to Lagarde to get them there.