King is bold and brave

The Bank of England decided to increase the size of its asset purchase facility by GBP 75bln at yesterday’s MPC meeting, whilst keeping the benchmark interest rate unchanged at 0.50%. The increase in QE was not wholly unexpected, with the debate mainly around whether the Bank was going to wait another month and choose to do it in its inflation report-meeting next month. The increase in asset purchases is perhaps on the lighter side of expectations, with the pace of purchases over the next four months equalling that of the first period of quantitative easing from March 2009 to February 2010.

Once again, the Bank is constrained largely to buying government bonds as part of this facility, although the Chancellor did say in his letter to the Bank that private securities may also be purchased. It was only three months ago that there were still members of the MPC that were looking to increase interest rates, so today’s announcement marks a notable shift in the collective thinking of the MPC (more on this when the minutes are released in two weeks time).

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Even though inflation is still likely to nudge 5% in coming months, the reasoning for the move is simply that the MPC now sees inflation coming in below 2% on the two-year horizon over which it sets policy. We’ve seen the initial impact both on the pound and the bond markets, the former down nearly one big figure, whilst 10yr bonds have around shed 10bp on the announcement.

Ultimately, the Bank wants to see the impact via the use of bank reserves to purchase other assets. Whether this will happen in the form desired as the sovereign crisis takes hold in Europe is another matter. Furthermore, when QE started in 2009, there were a lot of assets at distressed prices. This is far less the case this time around, with the main distressed asset (peripheral eurozone debt) looking far from alluring. QE2 is going to be very different to its predecessor.



ECB’s opportunity to cut rates and move on. The only thing preventing the ECB from cutting rates yesterday was Trichet’s pride. That said, the ECB did introduce a number of measures designed to improve money market conditions, including a 1yr tender in November and a 13mth tender   in December (to straddle the year-end). The ECB also committed to full allotment at its regular liquidity-providing operations out to the middle of next year.   Furthermore, Trichet announced a resumption of the covered bond-purchase program. Whilst Trichet should credited with being the first to the table to provide unlimited liquidity to eurozone markets in the summer of 2007 (King was still citing moral-hazard arguments), there are many elements to his tenure that we hope will end with his Presidency.   These include:   1) The ‘pre-announcement’ of rate moves with language such as “strong vigilance”.   This did nothing to clarify the policy-making process and in some ways undermined it. If the case for changing rates in a month’s time is there, the pre-announcement effectively moves market rates to that level, which then begs the question why not move rates today? 2) The ECB’s inability to learn the lessons from the credit crisis to date.   Inflation targeting was undermined by the credit crisis of recent years, but the ECB simply failed to appreciate this. Trichet’s dogged defence of the ECB’s inflation record last month underlined that he had just not grasped the wider lessons with respect to financial stability and underlying risks. The tightening in July was a manifestation of this. 3) The consensual approach to policy decisions. If we are to believe the messages that have emanated from Trichet and also his predecessor, there has barely ever been dissention on an interest rate decision. That 23 people all agreed with the July decision to increase rates was astounding given the risks that were prevalent at the time, but also in relation to other central banks. We live in very uncertain times (hence the divisions at the Fed, BoE etc.) and a committee should be there to voice and reflect any uncertainties.   There are signs that we are moving in this direction with today’s decision a “consensus” rather than being “unanimous” as was case in July.   The ECB needs to be more open on this; it’s not something to be ashamed of. Mario Draghi has an opportunity for policy reform which should start with the easing of rates in November and then the reversal of some of the above positions that emerged or continued under Trichet.


Bank recapitalisation talk triggers short-covering. The major driver of the short-covering in risk assets over recent days has been the growing sense that European leaders now understand the urgency of recapitalising their banks. High-beta currencies have enjoyed a reasonable bounce – for instance, the Aussie almost reached 0.98 overnight after briefly trading below 0.9400 on Tuesday afternoon. Even more dramatic has been the recovery in some of the Latam currencies: the Mexican peso for example has appreciated by 4.7% from its low against the dollar on Tuesday, while the Brazilian real has jumped by 7.2% over the same period. Interestingly, with the dollar giving back a little of its heady gains of the past few days, the Swiss franc has actually managed to underperform even the greenback. How times have changed. EUR/CHF reached 1.24 at one stage yesterday, amidst growing speculation that the SNB might just adjust its target for this critical cross before too long. In contrast, both the single currency and the pound have barely benefitted from the dollar’s softer tone. The EUR looked dreadful as Trichet started his press conference, dipping below 1.3250 before recovering to above 1.34, while cable collapsed to below 1.53 after the MPC’s decision to conduct an extra GBP 75bln of asset purchases. In the near term, the dollar remains vulnerable if risk-takers decide to cover more of their shorts. Over the last few months, the selling of risk assets across equities, commodities and high-beta currencies has been truly monumental. High-beta currencies would enjoy some solace should risk appetite make even a tentative return.

SNB smoke and mirrors. The jump in SNB’s currency reserves last month was no surprise, but just what effort was required to keep the 1.20 cap on EUR/CHF was not really evident. Valued in CHF, reserves increased EUR 29bln in September. On our calculations, just on the day of the announcement itself, reserves valued in Swiss francs would have increased CHF 17.5bln, not a bad day for SNB President Hildebrand who used to be a hedge fund manager. So, using a simple back-of-an-envelope calculation, one could say that reserves increased CHF 11.5bln over and above the initial jump owing to revaluation. Does this mean that the SNB spent the equivalent of CHF 11.5bln in buying euros and selling francs to curtail CHF appreciation? No, because things are more complicated than that. The SNB has continued to undertake cross-currency swaps and there have also been reports of the SNB selling euro puts below the 1.20 level, so the actual amount of euro sales is likely some way short of this amount. If true, then this would be another example of the SNB acting more like a hedge fund, pocketing the premium from the expiration of these puts which, post-peg, would not have been worth a lot, but done in size would still be a decent return. So far, it appears that the SNB has been successful in defending the CHF ceiling and talk of a cap of 1.30 or 1.40 from the Swiss Secretariat for Economic Affairs yesterday put even more money into the SNB’s coffers. However, defending the peg in the long term is still likely to prove a costly affair for the SNB.

More sense from Merkel. Angela Merkel is doing a commendable job right now despite occupying the boiling hot seat of German Chancellor. Very few would willingly swap roles with her as she attempts to negotiate a path for Germany through the eurozone sovereign debt quagmire that does not involve financial impoverishment. For the first time, she intimated that the EFSF could be used as a vehicle to recapitalise European banks, but only as a last resort. She pressed troubled banks to proactively seek additional capital from the private sector, and if that is not possible, for the state to step in. Only if a country did not have sufficient financial resources could the EFSF then be called upon to help out, under strict conditions. The IMF’s European department head suggested yesterday that as much as EUR 200bln of additional capital might be required to put European banks onto a firmer footing. Separately, Merkel confirmed what is now regarded as obvious, namely that the level of private sector burden-sharing in the second Greek bailout will need to be raised. Constructively, the focus of the immensely complicated debate in Europe on its sovereign debt and banking crisis is now concentrating on this critical question of bank recapitalisation. According to yesterday’s FT, the European Banking Authority (EBA) has already commenced a new round of stress tests which is expected to incorporate much more realistic markdowns for peripheral European sovereign debt. This is a very welcome development. Finally, Europe’s leaders are starting to get it.

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