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Publication for professional investors
Experts of NN IP give their vision on current economic and market developments
May 2017
Jeroen Rodigas, Senior Portfolio Manager Money Markets at NN Investment Partners,
discusses 5 ideas to reduce the negative side effects of the ECB’s policy measures.
How to reduce negative side effects of ECB policy
With a broad improvement in economic data and a brightening
outlook for the European economy, the negative side effects of the
ECB’s negative interest rate and quantitative easing (QE) policies
are coming into focus. Jeroen Rodigas, Senior Portfolio Manager
Money Markets at NN Investment Partners, lists five ideas that
could reduce the negative side effects of the non-standard policy
measures currently in place.
Negative side effects of unconventional ECB policy
Negative rates and quantitative easing (QE) have been with us for a
while now. The deposit rate turned negative in June 2014 and QE
was introduced in March 2015. Both are expected to stay with us for
at least one more year. NN Investment Partners’ Senior Economist
Willem Verhagen wrote a column on this matter, which can be read
here1. While there are still very good reasons to keep a very high
degree of policy accommodation, the negative side effects of this
policy are becoming increasingly difficult for the ECB to ignore.
In this Spotlight we discuss ideas that have been floated recently
that reduce the negative side effects of the non-standard policy
measures currently in place, ranked based on our perceived likelihood of making it into ECB policy.
Figure 1: Repo rates (%)
Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17
German repo rate
Examples of these side effects can be found all over the money
market space. The reverse repo market, for instance, hit lows of
-6% on specific bonds over year-end, largely driven by collateral
scarcity (see Figure 1). This in turn influences the short end of the
government bond market. In anticipation of a year-end collateral
squeeze, 2-year German government bond yields traded 15 basis
points higher compared to mid-November, while Eonia swaps
remained largely unchanged (see Figure 2). But it is not just the
secured reverse repo market that is impacted. The unsecured
market is impacted as well as banks are flooded with cash, resulting
from the ever increasing excess liquidity. Some banks show their
lack of interest to attract additional liquidity by reducing their cash
levels, as reflected by ever decreasing Euribor-Eonia spreads, while
others refuse taking cash altogether (see Figure 3).
Market participants have for a long time recognized these distorting
effects, but have treated it as a necessary evil to fight deflationary
forces and lowflation. Recent improvements in unemployment and
HICP inflation data however have practically eliminated deflation
fears. Positive economic surprises have sparked a more positive outlook for European growth and, to a lesser extent, (core) inflation.
With this more positive outlook, the medicine’s side effects have
come into focus.
Italian repo rate
Euro repo rate
Source: Bloomberg, NN Investment Partners
Figure 2: 2-year bond yields (%)
Jan-17 Apr-17
EUR Swap (EONIA) 2yr
Source: Bloomberg, NN Investment Partners
Jeroen Rodigas
Jeroen is Senior Portfolio Manager in the Cash
Solutions & Investments team within the Balance
Sheet Management (BSM) Boutique of NN
Investment Partners. He is responsible for the
management for the various Money Market funds
and strategies and for the cash activities of BSM.
Publication for professional investors
May 2017
Figure 3: Euro money market rates (%)
% 0.2
€ billion
Feb-14 Jun-14 Oct-14 Feb-15 Jun-15 Oct-15 Feb-16 Jun-16 Oct-16 Feb-17
Excess Liquidity (rhs)
Lending rate
Deposit Facility outstanding (rhs)
ECB Refinancing rate
ECB Deposit rate
ECB Marginal
Euribor 3M
Source: Bloomberg, NN Investment Partners
1. Expanding the Securities lending of holdings under the
expanded asset purchase programme (APP)
Since 2 April 2015, securities purchased under the public sector
purchase programme (PSPP) have been made available for securities
lending in a decentralised manner by Eurosystem central banks.
As of 8 December 2016, Eurosystem central banks have the possibility to also accept cash as collateral in their PSPP securities lending
facilities without having to reinvest it in a cash-neutral manner
(source ECB). The securities lending programme of the ECB is
designed to improve the functioning of the market by reducing
failed settlements as a result of ECB interventions in the government
bond market (one of their very few admissions that ECB policy is
negatively impacting the functioning of short-term markets).
On 6 December last year, the ECB extended its programme by also
accepting cash for lending out government bonds. This was done
to avoid a collateral shortage over year-end. While the programme
succeeded to avoid a collateral shortage, there was still a significant
collateral squeeze, with rates reaching -6% over year-end.
Expanding the current scope (the ECB is primarily targeting market
participants with market-making obligations) and size (EUR 50 billion,
split over six national central banks) would be a relatively straightforward step in limiting the impact of QE. To put the current size in
perspective, the ECB is buying EUR 60bn in securities a month and
with this programme it is only making a maximum of EUR 50bn
available again. As the costs to borrow securities from the ECB are
significant, the current programme should be viewed as a last resort.
Therefore increasing the size and scope may reduce stress on reporting dates (year-end and quarter-end), but should have only a limited
impact on money market rates in general. We view this option as
most likely as it is already in existence, does not interfere with their
monetary policy targets and is squarely aimed at improving the
functioning of the markets.
2. Opening up the deposit facility to a broader audience
An interesting idea, floated independently by Rabobank and
Nomura economists, is the opening up of the deposit facility to asset
managers and other financial institutions. Currently only Monetary
Financial Institutions (MFIs) have access to the ECB’s deposit facility.
With excess liquidity at 0, which was the case before the introduction
of LTROs, TLTOs and QE, this was not an issue as banks are competing
for liquidity from asset managers, corporates, individuals etc.
The idea basically comes down to giving non-MFIs indirect access to
the ECB through banks. With excess liquidity at EUR 1.5 trillion and
growing, banks no longer want to facilitate that indirect access for
non-MFIs. This reluctance is mainly driven by regulatory constraints
and the desire of banks to shrink their balance sheets (taking cash
from asset managers and placing it directly at the ECB is inflating
bank balance sheets without adding much to bank profitability). Also
in this part of the money market the functioning is more and more at
risk as asset managers and corporates alike are faced with banks
unwilling to accept their cash, especially at reporting dates. This is
forcing many to look for alternatives for parking short-term cash,
further driving short-term government bond yields lower. This
should not only worry market participants that do not have direct
access to the ECB’s facilities, but also the ECB itself, as the ECB policy
rates are becoming relevant for a smaller audience by the day.
Taking out the middle man and providing direct access for non-MFIs
would shrink bank balance sheets, reduce the cost of holding cash to
corporates and savers, allow the ECB to regain control of short-term
rates and significantly improve the functioning of money markets.
The effectiveness of this program, like any other proposal in this
note, depends on its size, scope and price. Should the deposit facility
become available in unlimited size to asset managers and large corporates at a rate equal to the current deposit facility of -0.4%, the
market impact could be significant. After all, why buy a government
bond for cash management purposes if you can park your cash safely
at the ECB? Short-term rates should get re-anchored again to the
ECB’s policy rates as this should be valuable to the central bank
when the time comes to raise rates. There are a lot of good reasons
why this plan should be considered. Arguments against it are legal
challenges surrounding its implementation, potential unfair competition from asset managers due to their less strict regulatory framework compared to banks (this can be solved by making it available at
a lower rate, -0.5% for instance). Another argument against it could
be the tightening effect it has on monetary conditions, which is at
odds with the ECB’s very accommodative policy. We would argue
however that it re-anchors short-term rates to the ECB’s policy rates,
which is a good thing.
3. Introducing a tiered deposit rate
A tiered deposit rate would mean the ECB charges a more punitive
rate on balances exceeding a certain threshold. The lower/more
punitive rate would be for policy setting (mainly through the FX
channel) while the higher deposit rate would protect banks and
savers from the costs of the negative rate policy. A tiered deposit
rate has already been on the ECB’s agenda in March 2016, but was
then decided against due to the complexity and diversity of the
Eurozone’s banking system and the ECB’s desire not to signal that it
can take rates as low as it wants. Without a tiered deposit rate there
actually is a lower bound; if the ECB takes the deposit rate negative
enough, people will bring their cash outside of the control of the ECB
by holding physical cash instead of leaving it in the banking system.
Publication for professional investors
While the complexity and diversity is unchanged, the signalling has
lost in importance now that market participants are no longer pushing for lower rates as deflation fears have abated.
The ECB acknowledges that there is a cost to the banking system of
having a negative deposit rate, but sees the benefits exceeding the
costs. Benefits come from better economic conditions due to the
ECB’s policy leading to lower non-performing loans (NPLs). With
the excess liquidity ever increasing and the economy picking up, the
balance between costs and benefits is changing for the worse and a
tiered deposit rate can ensure the balance stays in favour of the
ECB’s policy. The impact on money market rates of above policy
would likely be limited, as it should improve bank profitability. A
more profitable bank is a safer one and one that is more willing to
lend, both positives. It does not interfere with the policy setting and
could ease some of the political constraints the ECB might be feeling.
May 2017
Upward pressure on short-term rates is likely
For our portfolios this means that, for the first time since 2013, we
are facing potentially higher rates on a 1-year horizon again. Our
base case is that only expanding the Securities lending of holdings
under the expanded asset purchase programme (APP) will make it
and that QE will continue at EUR 60bn a month until the end of the
year, followed by gradual tapering of asset purchases and a first rate
hike in Q3 or Q4 of 2018. Market pricing is in line with this base case,
but as laid out above, there are risks to the upside. Even if none of
these ideas actually make it into policy, there can be upward pressure on short-term rates as good ideas are hard to kill. The ECB may
have put them on hold for the time being, but if economic data
stay strong and distortions in the money markets become painfully
visible these ideas will resurface, pushing up money market rates.
We keep a short duration profile in the absence of any reward for
this risk.
4. Narrowing the policy corridor
The ECB sets policy using three rates; the marginal lending rate
(+0.25%), main refinancing operations announcement rate (refi rate,
at 0%) and the deposit facility (-0.40%). In a world without excess
liquidity, money market rates float around the refi rate with the marginal lending rate and deposit facility rate acting as upper and lower
bounds. In today’s world only the deposit facility really matters for
money market rates, as all (excess) cash ultimately gets parked at
the deposit facility of the ECB. Since November 2015 the corridor
has been asymmetric; the deposit facility has been lowered more
than the other policy rates. To reduce the cost of the negative
deposit rate to the banking system, the ECB could bring the symmetry back by raising the deposit rate to -0.25% without signalling the
start of a new tightening cycle. As the deposit facility is the relevant
benchmark for money markets at this point in time, we expect this
measure to raise all short-term rates by about 0.15%. This might be
considered an unwarranted tightening of financial conditions, but
could be the outcome of a compromise needed to extend QE beyond
the comfort zone of some of the more hawkish ECB members.
5. Changing the sequencing of rate hikes and QE
The ECB has always stated very clearly in its forward guidance that
“rates will stay at present or lower levels for an extended period of
time and well past the horizon of our net asset purchases”. In March
however, some governing council members cast doubt surrounding
that statement by saying that the deposit rate could be raised before
or in tandem with the tapering of QE. In the March ECB meeting
Draghi added to this uncertainty by saying the forward guidance was
an expectation, not a commitment. Since then, the ECB has reiterated its policy stance, clearly explaining to the markets why the
sequencing of first tapering QE before raising rates makes a lot of
economic sense and markets have repriced accordingly. To summarize their rationale, the goal of QE is to reduce the term premium by
buying longer dated assets, leaving open the possibility that rates will
rise increases the term premium, basically offsetting any benefits
from QE. Therefore it is very important that the forward guidance is
strong and there should be no doubt about the ECB’s intentions.
Given the strong economic rationale and elaborate communication
on this topic we attach the lowest likelihood to this scenario.
Publication for professional investors
May 2017
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