UBS: Hot Potato
The ECB managed to deliver a more comprehensive set of policy measures than expected. However, the market reaction was not very positive as the ECB shifted away from interest rate policies in favour of non-conventional measures.
15.03.2016 | 08:54 Uhr
In particular, the ECB introduced a new targeted long-term refinancing operation (TLTRO) which, unlike the previous version, has a far greater potential size and more favourable conditions, including paying banks to borrow from it.
It is always a bit disheartening when you lay on a big surprise for somebody, and after the initial flush of joy they are clearly disappointed with it even though they had no idea it was coming. This is exactly how the President of the European Central Bank (ECB), Mario Draghi, probably felt on Thursday.Not only did the ECB deliver on market expectations of a further cut in deposit rates to -0.4%, but they surprised by increasing the pace of quantitative easing (QE) purchases, expanding QE to cover investment-grade credit, and introduced another round of targeted long-term refinancing operations(TLTROs) for banks. Yet after an initial risk-on rally the market quickly reversed to end the day worse than it started.
Perhaps Mr Draghi committed the sin of over-confidence. Everything looked happy in the markets until they heard him rule out further cuts to interest rates. The currency markets definitely didn't like it - the EURUSD appreciated about 2% against the pre-announcement level, reversing an initial 1%rally. Government bond yields also rallied and then sold off, with yields ending higher. Equity markets had much the same initial reaction, but after a good night's sleep decided that on balance the surprise was a welcome one.
Equity markets probably have the measure of it. The potential increase in the ECB balance sheet from these measures could be huge, much larger than that brought about by the QE that has been purchased so far. Before QE, the ECB increased its balance sheet through the first LTRO in 2012 (which was not explicitly targeted to increase lending at the time), but the balance sheet then shrank when the LTRO was paid back (chart 1). QE has increased the balance sheet, and the pace is increasing. But on top of that we now have another TLTRO programme, which, with full take-up, could help double the ECB balance sheet over the next two years.
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