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The package announced by President Draghi today was broadly in line with what economists had expected (including a 10bp depo rate cut, time extension of QE until at least March 2017, and inclusion of regional and local government debt in the PSPP) but it did fall short on some relevant dimensions compared with our expectations of a strengthening of the forward guidance. It also disappointed the market significantly and led to stronger euro, higher bond yields and lower stock prices.
First, it fell short in providing stronger forward guidance, for example by extending QE at least until inflation forecasts reach 2%, or by explicitly mentioning the possibility of more deposit rate cuts, although unlike in September 2014, there was no reference to a lower bound this time.
Second, it did not remove the yield floor for government bond purchases, which would have also re-inforced the forward guidance, and increase somewhat the pool of eligible assets, although such a decision could be announced at a later stage.
More importantly, the announcement also fell short of what the market had been expecting, especially as the market had priced a larger cut to the deposit facility of over 15bp for December. As a result, the euro appreciated to about 1.08 vs the USD (from 1.055) and the 5y5y euro HICPx swap was down by 4-5bp.
The ECB also announced the reinvestment of bonds that it had purchased or will purchase under the PSPP. This does not come as a surprise as such a measure had been implemented by other large central banks in the context of QE (eg, the Fed and BoE). Reinvesting the bonds purchased is clearly intended to extend the degree of monetary accommodation after March 2017, keeping the liquidity surplus ample for a longer horizon. When the shorter-dated bonds of the PSPP will start maturing after March 2017 (two years after the start of the QE programme), this measure will prevent an unwarranted tightening of monetary conditions.
As for the extension of QE to include regional and local debt, according to our data German regional states have EUR157bn of fixed rate EUR-denominated benchmark debt outstanding while Spanish regions have only EUR28bn in nominal terms, so EUR185bn in aggregate. However, the potentially eligible universe of bonds (ie, those in the 2-30y maturity boundary and yielding more than the -0.2% limit) is only EUR120bn in nominal terms (EUR10bn in Germany and EUR17bn in Spain) as over a third of the German sub-sovereign debt has maturity less than 2y. In cash terms, the size of the eligible universe is only marginally bigger at EUR129bn (EUR110bn for Germany and EUR19bn for Spain).
"We believe that the fact that macroeconomic developments have been surprising slightly on the upside over the last two months for the euro area may have played a role in the GC's decision against more aggressive monetary accommodation in December", says Barclays.
President Draghi clearly pointed at the success of the extraordinary monetary policy measures thus far, including an improvement of bank lending conditions, narrowing spreads between large firms and SMEs, and a compression of spreads between lending rates in vulnerable countries vs. core countries. Further, President Draghi underscored that in the absence of these extraordinary measures, inflation would be at least 50bp lower in 2016 and 1/3 pp lower in 2017.
Regarding the updated macroeconomic forecasts, the ECB left the projections largely unchanged. Specifically, inflation was marked down in both 2016 and 2017 by 0.1%, while real GDP growth in 2015 and 2017 were marked up by 0.1%.
Last but not least, President Draghi repeated that monetary policy had to be complemented with decisive actions in other policy areas. Once again, he mentioned that fiscal policies should support economic recovery "while remaining in compliance" with rules. Asked whether it means that some countries including Germany should ease fiscal policy, he declined to comment and left it to the European Commission to express a view about that. He also mentioned as usual the need to pursue effective structural policies, including the provision of adequate public infrastructure.
"We can see two reasons why the GC has under-delivered vs. expectations: the first is that there was not enough support for a lot more monetary accommodation given that the economic situation has been roughly in line with expectations, especially as some GC members (in particular Jens Weidmann and Sabine Lautenshläger) recently suggested that there was need for further monetary easing. The second reason is that some GC members may believe that moral hazard was becoming an important issue as member states are delaying structural reforms and are not delivering the appropriate fiscal stance", added Barclays.
