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Publication for professional investors Experts of NN IP give their vision on current economic and market developments May 2017 Spotlight 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 (%) 0 -1 -2 -3 -4 -5 -6 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. 1 www.nnip.com Italian repo rate Euro repo rate Source: Bloomberg, NN Investment Partners Figure 2: 2-year bond yields (%) 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 -1 Apr-15 Jul-15 Netherlands Oct-15 Italy Jan-16 Spain Apr-16 Germany Jul-16 France Oct-16 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. www.nnip.com Publication for professional investors May 2017 Figure 3: Euro money market rates (%) 1600 0.8 1400 0.6 1200 0.4 1000 % 0.2 800 0 600 -0.2 400 -0.4 200 -0.6 0 € billion 1 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 EONIA 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. 2 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. 3 Publication for professional investors May 2017 Disclaimer This document has been prepared solely for promotional purposes and does not constitute an offer, in particular a prospectus or any invitation to treat, buy or sell any security or to participate in any trading strategy. This document is intended only for MiFID professional investors. While particular attention has been paid to the contents of this document, no guarantee, warranty or representation, express or implied, is given to the accuracy, correctness or completeness thereof. Any information given in this document may be subject to change or update without notice. Neither NN Investment Partners B.V., NN Investment Partners Holdings N.V. nor any other company or unit belonging to the NN Group, nor any of its officers, directors or employees can be held directly or indirectly liable or responsible with respect to the information and/or recommendations of any kind expressed herein. The information contained in this document cannot be understood as provision of investment services. If you wish to obtain investment services please contact our office for advice. Use of the information contained in this document is solely at your risk. Please note that the value of your investment may rise or fall and also that past performance is not indicative of future results and shall in no event be deemed as such. This document and information contained herein must not be copied, reproduced, distributed or passed to any person at any time without our prior written consent. The document is not intended and may not be used to solicit sales of investments or subscription of securities in countries where this is prohibited by the relevant authorities or legislation. Any claims arising out of or in connection with the terms and conditions of this disclaimer are governed by Dutch law. 4