Les banques centrales et les marchés : la bataille du « toujours plus »

Key points: 

  • Central banks and markets: the battle of Evermore
  • ECB and the 33% threshold: ‘’damned if you do, damned if you don’t’’
  • The euro and the dollar: breaking up is so hard to do
  • Brexit and the Welsh solution

The battle of Evermore

Sometimes monetary policy is akin to feeding dragons: markets tend to be insatiable, and they may end up burning you.

Indeed, there seems to be no end to what the market wants from central banks. We have seen it in the immediate market reaction to the European Central Bank (ECB)’s press conference last week – hinting at a cut and possibly more was not enough – and this week to the Fed’s 25 basis point (bp) cut.

The risk is that this constant market yearning for ‘’more’’, which translates into the pricing along the curve, contributes to the deterioration in business confidence. If everyone – including policy-makers – focuses on the curve inversion, then the ‘’recession mood music’’ becomes louder.

But it’s not just about sentiment. New objective facts are fuelling the market’s gloom. Donald Trump’s announcement of a 10% tariff hike on USD300bn worth of imports from China on 1st September is important. While this is probably intended as a negotiating ploy (he could have gone straight to a uniform 25% or to immediate implementation), it is still escalation. The Peterson Institute calculates that with this new move the average tariff on Chinese imports will reach 21.5%, up from 18.3% today and 3.1% in 2017 before the trade war started. Since China accounts for roughly a fifth of total US imports, the overall impact on the US external cost structure has thus risen to 3.7%.

Still, as we have argued in a previous issue of Macrocast, the impact is not yet visible in prices. US import prices have been falling since the beginning of the year, with the deterioration in the global cycle pushing prices down and the dollar appreciating (+4.2% year-on-year in May in trade-weighted terms). But this additional move will probably further depress the global and US investment outlook.

The fact that the 10% hike was announced the day after the Federal Reserve (Fed)’s cut is not circumstantial. Even if Donald Trump would have wanted the Fed to go further, now that monetary policy has effectively accepted to provide pre-emptive support to the US economy against the fallout of the trade war, he probably feels emboldened. That is another uncomfortable feedback loop for the Fed. 

In his press conference, Jay Powell tried to strike a balance between avoiding a “one and done” interpretation and avoiding fuelling expectations for a full-on cycle of cuts. In the end, his communication is consistent with our baseline of another 25bp rate cut in September followed by a pause, but now that the Fed is in data dependent and risk watch mode, the odds of even more accommodation have risen with the materialisation of more “trade war risk”.

The ECB’s position is even more uncomfortable. Initially, the Fed choosing to cut by “25 bps only” and not sounding “panicky” during the press conference made the ECB’s position easier, with the euro falling back towards 1.10. But given the Euro area’s sensitivity to the global cycle, this new round of tariff hike is not good news. The market is unlikely to stop “asking for more”.

The ECB’s approach to the governments’ incentives has seemingly changed. In 2012, Draghi unleashed the “whatever it takes” storm only after the governments had pledged to make progress on dealing with the structural flaws of the monetary union – with a precise commitment on establishing the European Stability Mechanism (ESM) and banking union. “Whatever it takes” was a reward. This time the ECB is insistent that fiscal policy should take the lead in responding to the current downturn, but it is also happy to play up the possibility of more action on its side– including re-starting quantitative easing (QE) – although governments don’t seem keen to provide fiscal relaxation. The idea might be that core countries will in the end “consent” to a fiscal push as a “less bad” alternative to their savers facing evermore negative yields. The risk though is that fiscal authorities consider that since the ECB “is doing the job”, there is not much for them to do. Given how tricky a credible new round of QE could be, these considerations may end up percolating through the Governing Council.

The ECB and the 33% threshold: “Damned if you do”

Our ‘’monetary policy special’’ last week triggered quite a few questions from our readers, and one in particular – why is it so difficult to move the holding threshold of sovereign bonds above 33%? – has been made even more topical by the resumption of the German Constitutional Court procedure on QE. Let us re-state here in more details than before why we think it is a very delicate path on which to tread for the ECB.

True, in December 2018 the European Court of Justice (ECJ) did not make the “33% limit” a condition of its endorsement of the Public Sector Purchase Programme (PSPP). Rather, it listed a number of features of PSPP which ensured that governments would not be incentivized to conduct unsound fiscal policies (a key point in the complaint to the German Constitutional Court which triggered the ruling by the ECJ). Among these, the Court mentioned that “as a result of the purchase limits (…) in every case only a minority of the bonds issued by a Member State can be purchased by the ESCB (…), which means that a Member State has to rely chiefly on the markets to finance”. The word “minority” is usually interpreted as a sign the ECJ would in fact allow the limit to be eventually pushed to 50%.

The problem though is how the central banks would get entangled in a potential debt restructuring down the line. Indeed, if national central banks – which are the main agent and risk bearer of QE within the Eurosystem – were to exceed this 33% threshold, and the issuing national government were to pursue an unsustainable fiscal policy to the point a restructuring would be on the cards, they would be faced with three unpleasant options:

  • Option 1: agree to a debt restructuring, in which it would be the deciding force (33% is the “blocking minority threshold” under the Collective Action Clauses implemented since 2013). It would thus voluntarily engage in what would ultimately amount to monetary funding of a government, thus breaching the European treaty.
  • Option 2: continue buying “no matter what”, but then the ECJ would have trouble considering that the programme is not actually allowing the government to continue to pursue an unsound fiscal policy.
  • Option 3: accept an arrangement in which the government would default on the debt held by other investors while protecting the National Commercial Bank holding. This would go against the ECB’s constant assertion it is a “pari passu” investor and in effect “juniorise” the other investors, ultimately consistent with spread widening and thus becoming counter-productive.

‘’…damned if you don’t’’

But at the same time we have been arguing in Macrocast that resuming purchases of sovereign bonds while complying with the existing rules on quantitative easing would result in a very weak programme, at a time when the central bank is affirming the symmetry around its inflation target and thus needs to convince investors it retains ample room for manoeuvre once at the lower bound for policy rates.

In Exhibit 1, we look at the ‘’headroom’ on each sovereign bond market by first looking at how far from the 33% limit the Eurosystem is for the existing stock of bonds. Two national markets stand out: Germany and the Netherlands. Given the ECB’s attachment to using the ‘’capital key’’ to apportion the purchases (more on this later), we can derive from this how much more could be bought. The result with the ‘’German constraint’’ – EUR18bn of additional buying over the entire Euro area – is a paltry number (see Exhibit 2).

One can add to this the additional leeway stemming from the planned new net issuance of Bunds between now and the end of the year (EUR12bn according to BAML), 33% of which could be bought by the central bank. This would bring the total ‘’buyable’’ under PSPP to EUR33bn. Keeping the share of PSPP in the overall QE programme at its old share of 75% would push the overall ECB buying to 45bn, as per the bottom line of Exhibit 2.


So we are not surprised by the flurry of ‘’sneaky’’ ideas from the Street to deal with the two constraints – 33% and capital key – such as, in no particular order, extend the eligible universe beyond 30-year maturity, buy more ‘’proto-Bunds’’ in Germany (e.g. Laender debt) or reduce the share of PSPP in the whole programme. But all these solutions usually open the door to programmes of around EUR25/30bn per month, significantly lower than QE1.

Note that we are not overly excited by another “sneaky idea”: raising the holding limit beyond 33% for non-CAC bonds (i.e. bonds issued before 1st January 2013, c.40% of the German stock). Indeed, the Greek experience would suggest that “non CACable” bonds have a tendency to become “CACable” under national law…

In its current communication, the ECB argues that QE has lifted inflation by 0.2/0.25 percentage point (pp) in 2017 and 2018 relative to a counterfactual scenario. True, since the ECB will keep on reinvesting the ‘’stock’’ effect means that some support will linger into the next few years, but according to the central bank itself, the effect will fade over time (see the graphs in Philip Lane’s speech in Helsinki), and it is thus doubtful to us if €25/30bn of additional flows would be sufficient to realistically bring inflation back to target.

The Capital key is not easy to break

Anyone looking at our Exhibit 1 would normally conclude: the easiest is to get rid of the capital key, or at least use it as a looser “reference” (such as allowing purchases to continue on other national bond markets once one NCB is “stopped out” at 33%). However, legal issues cannot be fully discarded there either. We note in particular this excerpt of the ECJ ruling on PSPP: “ the distribution (…), of those purchases (…)in accordance with the key (…) means that the considerable increase in a Member State’s deficit resulting from the possible abandonment of a sound budgetary policy would reduce the proportion of that Member State’s bonds purchased by the European System of Central Banks (ESCB). Implementation of the PSPP does not therefore enable a Member State to avoid the consequences (…) of any deterioration in its budgetary position”. The capital key matters!

On all these legal issues it is very possible that the ECJ itself would remain lenient and find ways to allow the ECB considerable leeway…but this may not be the case for the German Supreme Court. A risk here is that Karlsruhe considers that while QE as it has been designed so far is fine, going beyond the current rules would make it impossible for the Bundesbank to participate. The German Court may not issue its ruling before a new round of QE is actually launched, but the perspective of an awkward legal situation may weigh on the Governing Council deliberations.

The euro and the dollar: breaking up is so hard to do

A lot of the current predicament of the ECB stems from its complex relationship with the signals coming from the US. This brings back the question of the Euro area’s financial autonomy.

We used a simple vector autoregressive (VAR) framework to trace mutual bond market spillovers, i.e. episodes when idiosyncratic developments in the Euro area affect the US and vice versa. As is clear from Exhibit 3, the Euro area bond market has almost always been more influenced by the US than the other way around.

This is even more obvious when looking at the exchange rate. If the international role of the euro was getting more traction, one would expect more and more third countries to peg their currency on the euro instead of the dollar. This would gradually insulate the Euro area from the impact of US monetary policy. And indeed, when we look at “breaks” in the relationship between the euro dollar and the euro’s trade weighted exchange rate, things initially looked promising. From 1999 to 2004, a 1% change in the euro dollar would result in a 0.6% change in the euro’s trade weighted index (TWI). From 2004 to 2010, this elasticity fell to 0.4. It looked as if the Euro area was getting more “independent”. However, we detected another break in 2010 and actually the elasticity has returned to 0.6.

This should obviously call for more efforts to turn the euro into a proper “reserve currency”. Some of the hurdles are contingent. A negative interest rate since 2014 may be hard to swallow even for non-profit seeking reserve managers. Others – such as the lack of progress on banking, capital market and fiscal union, and the absence of a joint risk-free asset – are more structural.

But Reserve currency status comes with some potentially problematic conditions. One is that its issuer must provide the rest of the world with a decent quantity of assets to invest in. This normally entails running a current account deficit. The Euro area since the Great Recession has on the contrary been generating a current account surplus. In those conditions, a permanent rise in the international demand for euros would take interest rates further into negative territory and trigger a significant appreciation in the euro’s exchange rate.

We would thus insist though on the need to make this part of a holistic strategy. Finally, setting up a common risk-free asset and some joint fiscal capability would make the euro more attractive as a reserve currency by helping to put the usual “existential concerns over the monetary union, while helping the Euro area to move away from high current account surpluses towards a more balanced model, more reliant on domestic demand, to make it less dependent on the gyrations in the global cycle.

Brexit and the Welsh solution

Since we are on the subject of dragons this week, it is only justice we should take a look at political developments in Wales. They matter for the political dynamics around Brexit. A pro-European Liberal-Democrat candidate has won a “Leave voting” parliamentary seat from a Tory in a by-election in Wales on Thursday. True, it used to be a Lib-Dem constituency until 2015 and there are other local specifics, but what is still interesting is that this victory owes a lot to a decision by two other pro-remain parties (the Welsh nationalists and the Greens) not to put up a candidate to maximise the chance of a “remain” win.

This is a tentative sign that the British political life is re-aligning around the “leave/remain” divide. The outcome of an early general elections is very difficult to predict but a Tory majority is still not guaranteed, although the party is leading again in the national polls. With Boris Johnson’s majority falling further after this by-election,  the likelihood of such early election is actually rising.

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