Base rates and balance sheets: where next for ECB and BofE?
0The decision by the US Federal reserve not to deliver new accommodation yesterday has raised the pressure on ECB President Mr Draghi to deliver significant measures today. At the same time, a range of press reports and official comments have managed expectations away from some of the more extreme policy steps markets were beginning to price in just last week.
To maintain the better tone in risk assets evident since Draghi’s comments last week, the ECB probably has to deliver some renewed balance sheet support for peripheral sovereigns. Ideally this would involve an indication that the ECB will resume direct secondary market purchases of Spanish debt, perhaps in conjunction with the EFSF/ESM.
A more transformative measure would involve plans to grant the ESM a banking license. This seems unlikely to be definitively promised this week, but it could be a topic discussed in the Q&A section of the press conference.
A less significant alternative, which might just suffice to prevent a severe disappointment reaction, would involve reduced haircuts on collateral and perhaps additional LTROs.
Measures today might be accompanied by further conventional policy easing, but it is unlikely that rate cuts alone would be sufficient to maintain the better tone in European sovereign markets.
That said, announcement of measures that engage the ECB’s balance sheet in a significant way in addressing the Euroland problems would further reduce systemic stress and Euroland risk premia.
If we use currencies as a summary of sentiment we can think through likely FX reaction to various possible scenarios:
| Policy step | Summary and market implication |
| Indications that ESM will be granted a banking license | A transformative step – could see EUR rally strongly against G10 currencies, and underperform rallying EMFX |
| Indications ECB will resume bond purchases | Supportive for risk – could see EUR rally modestly vs. core G10 currencies but underperform commodity bloc and EMFX. EUR gains vs. core should fade once initial benefit of reduced risk premium has run its course. |
| Reduced collateral requirements and/or further LTROs | Probably net disappointing but possibly sufficient to avoid a big risk sell-off |
| Traditional policy easing alone | Disappointing – could see the EUR lose ground vs. G10 but may squeeze higher vs. EMFX |
| No new measures | Disappointing – likely that the EUR loses ground vs. G10 but may squeeze higher vs. EMFX |
Ahead of the meeting, Spain is scheduled to auction €3bn in 2-, 4-, and 10-year bonds.
As for the UK, the Bank of England’s Monetary Policy Committee (BoE’s MPC) meet today, and the tone of last month’s minutes suggests that the MPC is likely to wait until it can monitor the effects of recent policy initiatives (the new ECTR facility and the FLS scheme) before taking further action. Given the split vote on Quantitative Easing (QE), and the evidence that some members view the ECTR and FLS as substitutes for more conventional policy, we should not expect an extension of asset purchases at this meeting. In addition, the minutes explicitly stated that any possible cut to the Base Rate would be unlikely to take place for “several months.”
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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