ECB running to catch up

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The ECB came out yesterday, but frankly it was too little and too late for markets. Its moves on liquidity and bond buying were not the cause of the global sell-off in markets, but nevertheless the fact that it was only buying Irish and Portuguese debt selectively did not inspure confidence. The sell-off in equities was the biggerst one-day fall since December 2008.  Currently, Asian stock markets are 3% to 5% softer.  In the US, yields on Treasuries have plummeted, down nearly 40bp this week, which is the biggest weekly decline since December 2008. 

In FX, EUR/CHF has achieved a new lifetime low, which means that Wednesday’s action on rates has hardly put a dent in the downmove. Actual intervention remains a risk, but the state of the ECB’s balance sheet (which it has said “…is no longer assured to the same extent.”) acts as a hinderence, as does the fact that it is probably all too aware it will be a futile gesture.  Given the extreme nervousness in markets at this point in time, the US employment report later today will take on even greater significance.  Markets are looking for an 85k gain, after the 18k gain seen in June.

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Commentary

ECB bond-buying seen as half-hearted.  Although not officially announced, the ECB restarted its bond buying program after its meeting on Thursday, but all the reports in the market suggested only Irish and Portuguese bonds were being purchased.  The fact that Spain and Italy were not included is pertinent, given these are the countries that have not received bail-outs. Some are interpreting it as a message from the ECB that more needs to be done on the fiscal side by both nations. Italian yields pushed new highs at 6.20% yesterday, with the same seen for Spain at 6.28%.  We won’t get the measure of this bond-buying until the week after next, given the settlement periods involved.

The start of the ECB u-turn.  We wrote after the last meeting that “the ECB appears to have forgotten that one of the main issues in a credit crisis is the breakdown in the monetary policy transmission mechanism” (7th July 2011). So one month after increasing its benchmark policy rate, the ECB has taken measures to address the breakdown in the monetary policy transmission mechanism, which was pushing market interest rates higher. Whilst the ECB is correct to split monetary policy measures (increasing or decreasing the policy rate) from measures to improve liquidity, they are nevertheless interlinked because the latter either helps or hinders the former. The bottom line; one month after an action to push market rates higher it has taken measures to push market rates lower. In themselves, the actions on liquidity were necessary to avoid an August 2007-style seizure in money markets, which was already in train. The ECB has re-introduced the offer of unlimited liquidity (for specified collateral) of 6-month maturity.  The euro’s initial reaction (softer) has come about on the softening of market rates that this move should bring. Secondary to this is the credibility angle of the ECB’s move today, together with the fact that it may be a precursor to the ECB making a u-turn on rates. The market has now priced out any further ECB tightening this year and, although gauging market expectations is difficult owing to various distortions (i.e. overnight rates trading over 0.5% below the ECB policy rate), the market will likely start pricing in lower rates at some point. Both rate increases from the ECB this year were a mistake and the ECB is now starting to dig itself out of the hole, largely dug due to its own inability to learn the lessons of the past few years.

Japan treads where the ECB doesn’t dare.  Switzerland and Japan share a common problem, but are undertaking fairly different approaches to dealing with it. The Swiss way was to flood the market with liquidity so as to push money market rates as near to zero as possible (3-mth Libor fell 4bp yesterday to 13.75bp), whilst we’ve seen some token measures on asset purchase and lending facilities from the Bank of Japan (BOJ) together with outright sales of yen. Perhaps not surprisingly the Japanese approach has been more effective so far, pushing the yen 3.5% lower vs. the USD, with the Swiss franc only 1.6% softer (2% vs. the euro).  For now, it appears that the SNB doesn’t want to go down the road of selling its currency on the open market. There are reasons for its reluctance, not least the composition of its balance sheet. Last year, the SNB made a CHF 26.5bln loss on its foreign exchange holdings (CHF 18.7bln from euro holdings), contributing to its overall loss of CHF 20.8bln. Being publically listed, this did not go down that well with shareholders. Furthermore, with the CHF strengthening between March 2009 and June 2010, there were also questions as to how effective the intervention had been.  In its annual report, the SNB noted that “the resilience of the SNB’s balance sheet is thus no longer assured to the same extent as hitherto”. In other words, its capital position is not as robust, with CHF 100bln of debt certificates sold in 2010 as part of its operations. When it comes to monetary policy, the SNB notes that “it must be carried out independent of balance sheet considerations”. It makes no such proviso with regards to currency intervention, which falls strictly outside of monetary policy (assuming full sterilisation of money supply effects). This is not to say it won’t intervene to attempt to curb Swiss franc strength, but it does mean that it’s a bigger risk and more calculated risk than for the BOJ.

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