Market commentary: Draghi steals the show

It was an eventful Thursday afternoon as Europe’s top monetary policy makers gathered in Frankfurt to deliver the proverbial ‘bazooka’ to a market with cautiously dovish expectations. Even before the full extent of the announcement began hitting home, many market participants felt the ECB had (finally, one might say) over-delivered. Indeed, when looking at the array of new policy implementations, it is hard not to feel that the ECB hasn’t covered all its bases. Let’s recap for a moment:

• Lower key ECB interest rates – Marginal Lending rate and Main Refinancing Operation (MRO) rate down by 5 basis points to 0.25% and 0% respectively. Deposit rate cut by 10 basis points to 0.40%
• Expanded Quantitative Easing (QE) , its asset buying programme to €80 billion monthly, an increase of 33%
• Expanded the eligible universe for QE by including euro-denominated investment grade non-financial corporates
• Announced a new series of four targeted longer-term refinancing operations (TLTROs), each with a maturity of four years, to be launched in June 2016. Interest on these instrument will be fixed and can be as low as the interest rate on the deposit facility

The first two measures were mostly expected. A deeper negative deposit rate penalizes banks who park their money at the ECB rather than lend it out, and also ‘brings in’ more Eurozone sovereign bonds to the QE-eligible pool of assets – the ECB cannot purchase bonds yielding less than the deposit rate.

An expanded monthly purchase allotment will help in supporting Eurozone sovereign bonds and those who hold them on their balance sheets. ECB President Mario Draghi also reiterated that QE purchases will run until a sustained pick-up in inflation is registered, and is not bound by the March 2017 ‘deadline’.

The decision to include corporates in the QE-eligible pool of assets was not on the cards, although it had been previously discussed. The idea behind this measure is to address a ‘hole’ in what the ECB calls its monetary policy transmission mechanism, whereby non-financial corporates were not benefitting as much as expected under the existing monetary policy stance. Similarly, institutions who hold these corporate bonds will be positively impacted by the anticipated rise in prices of such securities.

The second series of TLTROs (the existing ones will mature in September 2018) is aimed at providing what is objectively a cheap and stable funding source for a period of four years. The ECB will launch one in each quarter starting in Q3 of 2016, meaning that the last operation will mature in March 2021. Banks will bid at the prevailing MRO rate at the time, and might even get paid to borrow (!) if they have an active loan book. The more a bank lends, the less it pays (in this case, the more it receives) in interest, bounded by the prevailing deposit rate.

Right now you might be saying – wait, hold on… Getting paid to borrow money? Where’s the catch? Well, the amount you borrow the stronger sends a message to the market. If you borrow a lot, the market will assume you have large difficulties in funding yourself from the market. You might borrow very little, and while some investors may be comforted by that, some might say you needed to borrow more to see out a rough patch. Indeed, it is very hard to estimate what the ‘Goldilocks’ amount of borrowing is, but the general rule is that you don’t want to expose yourself too much to critique by borrowing vast sums of money. Trust is a very scarce commodity in financial markets, and it is very hard to rebuild once lost.

Market reaction

So how did the market react? Very well, for about an hour. Stock markets were up roughly 3%, 10-year bund yields fell some 7 basis points, and the Euro weakened. Happy days.

However when taking questions from the press, Mario Draghi seemed to counter what he had previously said (“rates will remain at present or lower levels”) by saying that “from today’s perspective… we don’t anticipate that it will be necessary to reduce rates further”. The ECB president added that this is contingent on the success of the announced measures and the current environment, also saying that the Governing Council decided against a tiered deposit rate as they felt it would signal no lower bound for negative interest rates.

Markets did not take that well, as they felt that further action from the ECB would only be forthcoming if things get drastically worse and, in any case, after a significant period of time when the success of today’s measures could be evaluated. The statement also after significant revisions lower to both growth and inflation forecasts (the ECB now expects inflation in 2016 to be just 0.1% as opposed to 1% previously), prompting many to think – or rather reinforce the belief – that we are heading for a prolonged period of low growth and inflation.

Equities sold off, closing well in the red as did Eurozone bond prices. The Euro skyrocketed against the US dollar, trading to a high of 1.1200 from a low of almost 1.08 in the aftermath of the announcement. Fast forward to this morning – yields have retreated and equities have recovered well, as the implications of the ECB package once again come to the fore. Low rates are essentially locked in until the next decade, providing yet more time and opportunities for the European economy to stand on its own two feet.

This article was issued by Andrew Martinelli, Trader at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.