Azad Zangana, European Economist
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For professional investors and advisers only. This document is not suitable for retail clients.
Given the timing of his comments last week, markets had rallied aggressively on expectations of further interest rate cuts and/or intervention in peripheral sovereign bond markets. Shortly before the eagerly awaited press conference both the Bank of England (BoE) and ECB announced decisions to hold their main policy interest rates at 0.50% and 0.75%, respectively.
ECB – Draghi disappoints
At today’s ECB press conference, Draghi announced that the ECB “may undertake outright open market operations of a size adequate to reach its objective (of price stability)”. Though at first glance Draghi appears to be announcing the start of quantitative easing, closer inspection of his opening statement and follow-up comments show that the ECB is merely considering the idea of creating a framework that could allow such action. There is not a great deal of conviction in the statement. Moreover, Draghi would not comment on the potential size of potential bond purchases, nor the timing, suggesting that the Governing Council may still be some way from agreeing how best to proceed, if at all.
Oddly, Draghi did state that any ECB purchases would be done using short-dated government bonds, hinting that the ECB would avoid buying longer dated debt. This suggests a sort of reverse operation twist, whereby the ECB’s purchases would only help governments raise finances in the short-term, ensuring that they are kept on a tight leash with higher long-term interest rates. Indeed, Draghi stressed the need to deal with the moral hazard problem of supporting governments in such a way. He stated that any intervention would only be done in the secondary market, and only after governments are meeting the conditionality set by European leaders and the International Monetary Fund.
So it appears that there is no chance of the ECB intervening in primary markets, and any intervention in secondary markets will only come after Spain and Italy request help. Of course, for Spain and Italy to successfully negotiate help with the Troika, they must show that they cannot raise financing through financial markets – in the same way Greece, Ireland and Portugal were forced to demonstrate. They must also agree to conditionality that is likely to be more severe that the austerity plans they are currently implementing, and that are pushing them deeper into recession.
The lack of detail and certainty over how the ECB intends to help is very frustrating. There are big questions around the scope and legality of its proposed policy tools. Will bond purchases be sterilised? How do they intend on dealing with the seniority issue with regards to existing bond holders. It is therefore no surprise to see stock markets in Southern Europe fall sharply in response to Draghi’s disappointing announcement. What is worse, it is clear that some members of the Governing Council oppose bond purchases (no prizes for guessing which). If the ECB does not follow up with some meaningful action in the near future, then there is a risk that markets lose all faith in Draghi and the Governing Council’s ability to tackle this crisis. Draghi warned investors not to bet against the euro. The trouble is Mr. Draghi, those that are doing so have done rather well so far this year.
BoE on hold
Elsewhere today, the BoE’s Monetary Policy Committee decided to leave interest rates at the record low level 0.5%, and its asset purchase programme (or quantitative easing programme) at £375 billion. Having only just increased its quantitative easing programme by £50 billion last month, there was little chance of more action from the Bank, despite the dreadful second quarter GDP figures published last week.
The BoE will publish its updated forecast fan-charts for growth and inflation next week in its Inflation Report, which will provide markets a signal of the prospects for more quantitative easing, or even a further cut in interest rates, as has been called for by the International Monetary Fund. However, we expect the BoE to remain in ‘wait and see’ mode, especially as it will want to assess the impact of the government’s ‘Funding for Lending Scheme’, which started yesterday.
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