Friday, December 4, 2009

ECB: Separating rate setting from liquidity provision

The ECB's decision to use the average minimum bid rate instead of the fixed 1% rate for its next and last unlimited 12m tender came as a surprise. Short rate futures initially fell on the news just to recover all the losses and more as Trichet stated that this would not signal anything with respect to the outlook for rates. And indeed if one looks at the ECB staff projections for GDP growth (2010 0.1%-1.5% and 2011 0.2%-2.2%) and inflation (2010 0.9%-1.7% and 2011 0.8%-2%), then there seems to be no need to change rates over the life of the upcoming 12m tender.
To me, yesterday's decision signals that a) the ECB acknowledges the uncertainty with respect to the macro-economic outlook and is happy to have this uncertainty also reflected in the LTRO, b) the ECB wants back to an increased separation between setting the price for liquidity (aka traditional monetary policy which is dependent on the macro-economic outlook) on the one hand and of ensuring a properly working transmission mechanism of monetary policy via the provision of liquidity on the other. With this they confirm that the systemic financial crisis has been abating but that at the same time the macro-economic crisis - aka muted nominal growth - might be past its most acute phase but clearly is far from over. Indeed the liquidity provision measures have done a lot to improve the working of the transmission mechanism of monetary policy compared to one year ago. Credit spreads have tightened drastically and markets have been digesting a huge amount of credit-related supply. In turn, it is warranted to reduce the amount of excess liquidity over the upcoming year.
However, it should not be forgotten that low yields per se are only a necessary but not a sufficient condition for the transmission mechanism to work properly. Liquidity has been ample hence the lower yields and increased appetite for risk. But capitalisation across the banking sector and/or the corporate sector and/or households in a large number of countries remains poor and therefore the provision of credit via the traditional banking channel is still very restrictive.
Moreover, the ECB's economic projections imply that nominal growth should be in between 1%-3.2% for 2010 and 1%-4.2% in 2011 with the central values at 2.1% and 2.6%, respectively. Historically, these are very low levels of nominal growth and should go hand in hand with a prolonged period of low nominal yields. I have used the chart below on numerous occasions. It shows the 10y UST yields (more precisely, the 10y constant maturity treasury yield) vs. US nominal GDP growth and vs. smoothed nominal GDP growth. Not surprisingly, the longer-term trends are the same for nominal yields and nominal GDP growth.

US nominal GDP growth and nominal yields are moving in tandem over longer term
Source: St. Louis Federal Reserve, Bloomberg, Research Ahead

In the Eurozone, the situation is the same even though we have less history available to prove the point. The chart below shows the development of nominal Eurozone GDP growth vs. 10y Bund yields since the start of 1999. There has been a close co-movement for the past 10 years with the exception of this year where nominal growth fell much more than nominal bond yields. This is down to the negative growth rate being a temporary one while the bond yield has a long maturity and should therefore not be only dependent on short-term growth but is largely influenced by the medium-term outlook.
In between January 1999 and Dec 2008, nominal GDP growth averaged 4.2% (based on 2.1% average real growth and an average GDP deflator of 2.1%) while 10y Bund yields averaged 4.3%. That the two averages are very similar should not be seen as a coincidence as nominal bond yields need to be closely linked to nominal GDP growth over the medium term.

Also in the Eurozone nominal yields and nominal growth are co-moving over the medium term
Source: Bloomberg, Research Ahead

The relationship of nominal growth and nominal yields in combination with the ECB's economic projections, supports my expectation that nominal yields should remain low for a pro-tracted period of time. Additionally, it should not be forgotten that if nominal growth should indeed be around 2.5% for a multi-year period, then 10y nominal Bund yields of 3-4% are not really accommodative. Furthermore, we should not forget that even with an unchanged level of the ECB repo rate of 1%, as core inflation continues to fall, the realised real interest rates for most market participants will be rising nevertheless during 2010.

To conclude, the ECB has started on its exit path with respect to the emergency measures enacted to support the financial system. It thereby tries to better separate rate setting from the provision of liquidity. It has made no decision with respect to its exit strategy from the record-low repo rate environment. This will be dependent on the outlook for inflation and growth and at present it does not look like 2011 will be the year of the first rate hike.

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