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The New World Ordoliberalism Part 6: The QE Taper Caper and the Portuguese Squeeze

With 2017 set to be a year of crit­i­cal elec­tions for euro­zone — includ­ing fed­er­al elec­tions in Ger­many, the Nether­lands, and France [1] with the poten­tial to reshape the euro­zone — and since these elec­tions are prob­a­bly going to be heav­i­ly shaped by the ongo­ing exis­ten­tial freak out the euro­zone’s wealth­i­er nations’ role in the euro­zone in rela­tion to the seem­ing­ly end­less euro­zone cri­sis, 2017 is prob­a­bly going to be an espe­cial­ly good year to point out that prob­lems with the euro­zone’s exist­ing struc­ture don’t include a prob­lem with a euro­zone dis­pro­por­tion­ate­ly harm­ing those wealth­i­er mem­bers. The prob­lem is quite the oppo­site: the euro­zone is designed to help those wealth­i­er mem­bers at the expense of its poor­er fel­low mem­bers.

And it’s set up to do this in a myr­i­ad of dif­fer­ent ways, most obvi­ous­ly the sys­tem­at­ic deval­u­a­tion of the cur­ren­cies of stronger economies cou­pled with the sys­tem­at­ic increase in the cur­ren­cies of weak­er euro­zone mem­bers. But, as we’ve seen with so many times of the “bailout” in the past, the “bailouts” them­selves are also one of the many way the euro­zone is designed, or evolved on the fly, to ben­e­fit the strong over the weak, often under the spir­it of “no one mem­ber can ben­e­fit more than the oth­ers”. The euro­zone is a strange con­struct if you haven’t noticed.

And in this par­tic­u­lar chap­ter of our explo­ration of what’s wrong with the euro­zone we’re going to take a look at the evolv­ing nature of the Euro­pean Cen­tral Bank’s (ECB’s) quan­ti­ta­tive eas­ing (QE) pro­gram. Specif­i­cal­ly, how the QE pro­gram was fac­ing a set of obsta­cles that was going to require some tweak­ing to the pro­gram and how the solu­tion to the obsta­cle was to basi­cal­ly choose the tweaks that harmed the weak, in par­tic­u­lar Por­tu­gal. In favor of Ger­many, of course. Keep in mind that Por­tu­gal recent­ly formed a left-wing anti-aus­ter­i­ty gov­ern­ment and has done rel­a­tive­ly eco­nom­i­cal­ly well since com­ing into pow­er [2]. Also keep in mind that Por­tu­gal is one of the few euro­zone nations not fac­ing a ris­ing far-right “pop­ulist” move­ment as a response to its harsh aus­ter­i­ty pro­gram [3]. So you might say the tim­ing is “right” for some pref­er­en­tial treat­ment of Por­tu­gal. Pref­er­en­tial­ly bad treat­ment.

First, let’s take a look at the sit­u­a­tion back in August, before these tweaks were put in place: The ECB was fac­ing a QE conun­drum. The QE rules state that the ECB can only buy euro­zone gov­ern­ment bonds under the fol­low­ing cri­te­ria (self-imposed cri­te­ria that the ECB cre­at­ed for itself ear­li­er):
1. The total bond pur­chas­es for a giv­en coun­try can’t exceed 33 per­cent of its sov­er­eign total bond mar­ket.

2. The bonds pur­chased can­not bear inter­est less than ‑0.4 per­cent.

3. Due to fears of QE becom­ing a back­door bailout for the cri­sis-rid­den coun­tries, all bond pur­chas­es must fol­low a “cap­i­tal key” that caps the max­i­mum bonds that can be pur­chased in a giv­en Euro­pean coun­try accord­ing to the size of that coun­try’s finan­cial sys­tem. In oth­er words, all coun­tries par­tic­i­pat­ing in the ECB’s QE pro­gram (all euro­zone coun­tries plus some oth­ers like the UK), would get equal stim­u­lus, rel­a­tive to the size of their economies and regard­less of the need, or lack there­of, for the QE pro­gram.

Those were the rules. And by August, almost half the euro­zone sov­er­eign bond mar­ket was held by the ECB (no one said clean­ing up a his­toric finan­cial cri­sis would be quick or casu­al) and a sig­nif­i­cant prob­lem was emerg­ing: Ger­many was run­ning out of bonds that were yield­ing above ‑0.4 per­cent. So if the QE pro­gram was going to con­tin­ue with­out break­ing the rules one or more of those three rules was going to have to be mod­i­fied [4]:

The Finan­cial Times
Fast FT

ECB set to run out of bonds to buy – Cred­it Agri­cole

August 16, 2016

by: Mehreen Khan

Liq­uid­i­ty, liq­uid­i­ty every­where and not a bond to drink.

In a world of record neg­a­tive yield­ing sov­er­eign bonds and ever-increas­ing dos­es of quan­ti­ta­tive eas­ing, the Euro­pean Cen­tral Bank’s bond-buy­ing blitz could soon hit the buffers.

The cen­tral bank’s €80bn-a-month debt spree will have hoovered up half the entire uni­verse of eli­gi­ble gov­ern­ment debt by the end of the year, accord­ing to analy­sis from Cred­it Agri­cole, writes Mehreen Khan.

With the ECB scram­bling around for paper, more than two-thirds of the sov­er­eign bond mar­ket that qual­i­fies for QE will be on the ECB’s bal­ance sheet by next Sep­tem­ber they pre­dict, leav­ing pol­i­cy­mak­ers scratch­ing their heads over how to extend stim­u­lus mea­sures.

And the scarci­ty prob­lem is pri­mar­i­ly Ger­man. Accord­ing to its own QE cri­te­ria, the ECB is now exclud­ed from buy­ing Bunds with a matu­ri­ty under sev­en years, as they have fall­en below the ‑0.4 per cent yield floor set by the cen­tral bank. That’s around 40 per cent of the entire Ger­man bond mar­ket, or €413bn accord­ing to fig­ures com­piled by Tradeweb.

Ger­many mat­ters. It is the largest econ­o­my in the euro­zone and thus makes up the sin­gle biggest pro­por­tion of the cap­i­tal key set out by the ECB for its total pur­chas­es.

“If the ECB can­not pur­chase Ger­man bonds, then it will have to change the modal­i­ties of its pur­chas­es”, says Louis Har­reau at Cred­it Agri­cole.

“Germany’s share in the ECB’s cap­i­tal is too big to be com­pen­sat­ed by sub­sti­tute pur­chas­es” he notes.

Ana­lysts wide­ly expect the cen­tral bank to tweak the terms of its stim­u­lus pro­gramme to broad­en the uni­verse of eli­gi­ble debt and ease the bond-sup­ply bot­tle­neck.

This can be done in three ways: by cut­ting the ECB’s deposit rate below ‑0.4 per cent; increas­ing the ceil­ing on its “issuer lim­it” from 33 per cent; and by shift­ing around with a “cap­i­tal key”, where pur­chas­es cor­re­spond to a mem­ber states’ pro­por­tion of over­all euro­zone GDP.

Mario Draghi, ECB pres­i­dent, has promised “flex­i­bil­i­ty” to ensure the cen­tral bank con­tin­ues to hits its month­ly pur­chase tar­get. But as ever in the euro­zone, pol­i­tics is set to throw sand in the wheels of any swift changes to the stim­u­lus pro­gramme, which was first launched in March 2015.

Jens Wei­d­mann, the uber-hawk­ish pres­i­dent of the Bun­des­bank and ECB board mem­ber, has cau­tioned against ramp­ing up pur­chas­es from the indebt­ed coun­tries of the south as it would threat­en the ECB’s cher­ished inde­pen­dence.

If “we focus more par­tic­u­lar­ly on high­ly indebt­ed coun­tries, we blur the bound­aries between mon­e­tary pol­i­cy and fis­cal pol­i­cy which con­tin­ues”, Mr Wei­d­mann said ear­li­er this month. [5]

But remov­ing polit­i­cal bar­ri­ers to action would not prove a panacea if the ECB wants to keep the mon­e­tary taps on past a notion­al Sep­tem­ber 2017 end date, notes Mr Har­reau.

He cal­cu­lates that remov­ing the deposit rate “will not be enough to alle­vi­ate the scarci­ty con­cerns” around Ger­man, Finnish, Dutch and Span­ish bonds should QE con­tin­ue after Sep­tem­ber 2017.

...

So what’s the best way to keep buy­ing time?

The most effec­tive option is also the bold­est: drop­ping the cap­i­tal key – where larg­er economies make up the biggest pro­por­tion of the month­ly pur­chas­es. This would like­ly skew QE towards small­er economies, allow the ECB to con­tin­ue snap­ping up bonds from Por­tu­gal and Ire­land (for­mer bailout coun­tries), and “remove down­ward pres­sure on core yields”, adds Mr Louis.

But it’s also the option that will be most polit­i­cal­ly unpalat­able for the larg­er north­ern cred­i­tor states of the euro­zone.

All in all, the best solu­tion to the ECB’s woes is one that would make the very neces­si­ty of QE pret­ty redun­dant – a grow­ing econ­o­my, ris­ing bond yields, and a nat­ur­al increase in the uni­verse of eli­gi­ble debt.

Chick­en and egg.

“The most effec­tive option is also the bold­est: drop­ping the cap­i­tal key – where larg­er economies make up the biggest pro­por­tion of the month­ly pur­chas­es. This would like­ly skew QE towards small­er economies, allow the ECB to con­tin­ue snap­ping up bonds from Por­tu­gal and Ire­land (for­mer bailout coun­tries), and “remove down­ward pres­sure on core yields”, adds Mr Louis.”

So back in August, it was clear some­thing had to be done to allow the ECB’s QE pro­gram to pro­ceed with­out run­ning out of bonds. And it was also pret­ty clear to observers that the most effec­tive way to tweak the rules would be to drop the “cap­i­tal key” rule so the ECB can focus its bond pur­chas­es on the coun­tries that need it most while avoid­ing the pur­chas­es of bonds in coun­tries like Ger­many where bonds are already in neg­a­tive ter­ri­to­ry. This was seen as the option that would be the most help­ful for the euro­zone as a whole, much more so than the oth­er options like low­er­ing the min­i­mum “deposit rate” yield on the ECB’s pur­chased bonds below ‑0.40 per­cent which would sim­ply allow the ECB to find more eli­gi­ble Ger­man bonds (since so many of them are already yield­ing below ‑0.40 per­cent) to keep the QE pro­gram going.

Por­tu­gal (and Ire­land) Approach the Lim­it and Pre­emp­tive­ly Devi­ate From the Cap­i­tal Key in Response

But also note that Ger­many was­n’t the only coun­try run­ning out of space to oper­ate in the QE pro­gram, some­thing that was obvi­ous ear­li­er in the year. As ear­ly as April, Por­tu­gal and Ire­land were fac­ing a dif­fer­ent kind of prob­lem and drop­ping the “cap­i­tal key” was­n’t going to fix it. At least not alone. That’s because Ire­land and Por­tu­gal were already on track to exceed the ECB’s 33 per­cent cap on the total vol­ume of bonds held for a giv­en nation before the QE pro­gram was set to expire in March of 2017 due to the fact that the ECB still has bonds from Por­tu­gal and Ire­land left­over from its 2010–2012 “Secu­ri­ties Mar­kets Pro­gramme” [6] (the first of the euro­zone cri­sis emer­gency respons­es). And as a result, the ECB’s QE bond pur­chas­es were already devi­at­ing from the “cap­i­tal key” for Por­tu­gal and Ire­land. And not in a help­ful way [7]:

Reuters

Wary of hit­ting lim­its, ECB holds back on Por­tuguese, Irish bond buys — sources

By Bal­azs Koranyi and John Ged­die | FRANKFURT/LONDON
Tue May 17, 2016 | 9:20am BST

The ECB lim­it­ed its sov­er­eign debt buys of Por­tuguese and Irish bonds last month due to con­cerns about hit­ting its pur­chase caps, cen­tral bank­ing sources said, in a move that could mean those coun­tries stand to ben­e­fit less from the scheme.

With almost a year left of its quan­ti­ta­tive eas­ing pro­gramme, the ECB is already near­ing a self-imposed lim­it of hold­ing a third of the coun­tries’ debt due to the large amounts of bonds it bought under pre­vi­ous cri­sis-fight­ing mea­sures.

This became an issue when the ECB increased its month­ly asset buys to 80 bil­lion euros in April from 60 bil­lion euros. Data shows that so far pur­chas­es have increased by more than 50 per­cent in most euro zone coun­tries but only by 16 per­cent in Por­tu­gal and 33 per­cent in Ire­land.

Two sources famil­iar with the sit­u­a­tion said the ECB and nation­al cen­tral banks that con­duct the buy­ing had sup­ple­ment­ed Por­tuguese and Irish bonds with the debt of supra­na­tion­als to avoid hav­ing to cur­tail buy­ing of their debt more rad­i­cal­ly or even hav­ing to cut them off com­plete­ly once it hits its lim­its.

The cur­tailed buy­ing means that the ECB’s sov­er­eign debt pur­chas­es will devi­ate slight­ly from the coun­tries’ share­hold­ing in the cen­tral bank, called the cap­i­tal key, pos­si­bly mut­ing the pos­i­tive mar­ket impact of the scheme in Por­tu­gal and Ire­land.

...

While QE has pushed bor­row­ing costs in the euro zone to record lows in many coun­tries, some investors say that uneven pur­chas­es of sov­er­eign debt could mean vul­ner­a­ble coun­tries like Por­tu­gal do not ben­e­fit as much as the bloc’s largest econ­o­my, Ger­many, there­by esca­lat­ing polit­i­cal ten­sion in the region.

“If the ECB is going to tar­get pur­chas­es on some sov­er­eigns at the expense of oth­er sov­er­eigns, then effec­tive­ly you have got an unequal appli­ca­tion of that mon­e­tary pol­i­cy,” said Mark Dowd­ing, a port­fo­lio man­ag­er at Blue­Bay Asset Man­age­ment.

“In extrem­is, you are say­ing that this is going away from a trend where you are try­ing to bring Europe togeth­er, and it is look­ing more like some­thing that could push Europe apart.”

LEFTOVERS

The sources said the ECB was keen to keep both coun­tries in the pro­gramme until the pro­ject­ed end of the scheme in March 2017, but said that the buy­ing could still fluc­tu­ate over time and that the ECB also reviews its issuer lim­it every six months.

Left over from its Secu­ri­ties Mar­kets Pro­gramme, a scheme launched in 2010 to tack­le an esca­lat­ing debt cri­sis, the ECB held 9.7 bil­lion euros of Irish debt at the start of 2016 while its Por­tuguese hold­ings stood at 12.4 bil­lion euros. Since the start of QE, the ECB has bought 11 bil­lion euros of Irish debt and 16.2 bil­lion in Por­tu­gal.

The ECB’s issuer lim­it also sug­gests that if Greece joins the pro­gramme, ECB pur­chas­es will be severe­ly cur­tailed as the bank is already one of the big­ger hold­ers of Greek debt.

The ECB has already stopped pur­chas­es in Cyprus because the coun­try does not have the nec­es­sary cred­it rat­ing and keeps sov­er­eign buys lim­it­ed in sev­er­al coun­tries, like Esto­nia, for liq­uid­i­ty rea­sons.

“This became an issue when the ECB increased its month­ly asset buys to 80 bil­lion euros in April from 60 bil­lion euros. Data shows that so far pur­chas­es have increased by more than 50 per­cent in most euro zone coun­tries but only by 16 per­cent in Por­tu­gal and 33 per­cent in Ire­land.

That was the sit­u­a­tion back in May, short­ly after the ECB expand­ed its month­ly QE bond pur­chas­es from 60 bil­lion to 80 bil­lion euros a month. Most of the euro­zone coun­tries saw a 50 per­cent increase in bond pur­chas­es but Ire­land and Por­tu­gal, two of the coun­tries that the QE pro­gram was intend­ed to help, were forced to under­shoot the increase rel­a­tive to what the “cap­i­tal key” would have called for.

But that was far from the only eco­nom­ic warn­ing sign flash­ing for Por­tu­gal at the time. As the arti­cle below points out, Por­tu­gal is just one cred­it rat­ings down­grade away from get­ting kicked out of the ECB’s QE pro­gram entire­ly. And if that hap­pens, Por­tu­gal will face a dilem­ma that’s now painful­ly famil­iar for the euro­zone: leave, or under­go anoth­er round of “bailouts” (bru­tal aus­ter­i­ty) with the hopes of reen­ter­ing the QE pro­gram lat­er [8]:

The Wall Street Jour­nal

Portugal’s Finan­cial Inde­pen­dence Hangs by a Thread
Country’s access to ECB bond-buy­ing pro­gram depends on debt rat­ing by Cana­di­an firm DBRS

By Patri­cia Kows­mann
April 29, 2016 12:30 a.m. ET

LISBON—Nearly two years after Por­tu­gal left a €78 bil­lion ($88 bil­lion) inter­na­tion­al bailout pro­gram [9], its finan­cial inde­pen­dence con­tin­ues to hang by a thread.

That thread is a lit­tle-known Cana­di­an firm, DBRS Ltd., the only rat­ing com­pa­ny that main­tains an invest­ment-grade rat­ing on Por­tuguese debt. That rat­ing gives Por­tu­gal access to the Euro­pean Cen­tral Bank’s bond-buy­ing pro­gram, which has kept bond yields low and rel­a­tive­ly sta­ble despite recent glob­al mar­ket tur­moil, a Decem­ber bank fail­ure [10] and fric­tion between Euro­pean Union offi­cials [11] and the country’s new gov­ern­ment over its bud­get plans.

On Fri­day, DBRS will announce the result of its twice-year­ly review of Por­tu­gal. A down­grade to junk status—the rat­ing the coun­try gets from Stan­dard & Poor’s, Moody’s Investors Ser­vice and Fitch Ratings—would force it out of the ECB pro­gram and raise bor­row­ing costs for its gov­ern­ment, banks and com­pa­nies.

That, in turn, could reawak­en fears over Portugal’s future in the euro­zone and the sus­tain­abil­i­ty of the bloc itself, which is strug­gling to man­age Greece’s fis­cal trou­bles. Por­tu­gal would be required to take a new bailout to get a chance to re-enter the ECB pro­gram.

...

“The fact that the country’s future in sov­er­eign debt mar­kets hinges upon a sin­gle deci­sion shows that Por­tu­gal is still in a very del­i­cate sit­u­a­tion,” said Anto­nio Bar­roso, an ana­lyst at polit­i­cal-risk con­sul­tan­cy Teneo Intel­li­gence. “It is also a reminder for politi­cians both in Lis­bon and in Brus­sels that they should be doing more in order to pre­vent a return of the cri­sis to the euro­zone.”

Dur­ing its three-year bailout pro­gram, which end­ed in May 2014, Por­tu­gal was con­sid­ered an exem­plary fol­low­er of the Ger­many-led aus­ter­i­ty mod­el. The cen­ter-right gov­ern­ment at the time, led by Prime Min­is­ter Pedro Pas­sos Coel­ho, cut pub­lic employ­ees’ wages, raised tax­es and slashed spend­ing to bal­ance its accounts. The bud­get deficit fell sharply, from close to 10% of gross domes­tic prod­uct in 2010 to 3% of GDP last year, exclud­ing a cap­i­tal injec­tion into a failed lender.

Mr. Pas­sos Coel­ho pri­va­tized state com­pa­nies and changed labor reg­u­la­tions to bring down labor costs and make exports more com­pet­i­tive.

Still, Portugal’s econ­o­my strug­gles. Exports are ris­ing, but so are imports. Invest­ments remain scarce. Unem­ploy­ment exceeds 12%.

The Inter­na­tion­al Mon­e­tary Fund pre­dict­ed recent­ly that Portugal’s econ­o­my would grow an aver­age of 1.3% a year over the next six years, too slow­ly to reduce a debt bur­den that stands at 129% of GDP.

Portugal’s per­cep­tion among investors has been hit by two bank fail­ures since 2014 and the elec­tion of a Social­ist-led gov­ern­ment that has raised the min­i­mum wage and promised to raise pub­lic-sec­tor wages and low­er tax­es.

Social­ist Prime Min­is­ter António Cos­ta, who took office late last year with the back­ing of three far-left par­ties, has soft­ened his rhetor­i­cal attack on his predecessor’s aus­ter­i­ty mea­sures. He has agreed to make deep­er bud­get cuts this year to avoid a fight with the Euro­pean Com­mis­sion.

...

Even if it man­ages to avoid a down­grade now, pres­sure on Por­tu­gal is expect­ed to grow.

DBRS has cit­ed a glob­al eco­nom­ic slow­down, debt sus­tain­abil­i­ty and a rise in bond yields as fac­tors to watch.

As he cuts the bud­get, Mr. Cos­ta could be forced to choose between alien­at­ing his far-left allies in par­lia­ment or con­fronting the Euro­pean Com­mis­sion and its fis­cal rules.

“The biggest con­cern that we would have would be [an] open con­flict with the Euro­pean Com­mis­sion,” Fer­gus McCormick, head sov­er­eign ana­lyst at DBRS, said in Feb­ru­ary.

Dur­ing its three-year bailout pro­gram, which end­ed in May 2014, Por­tu­gal was con­sid­ered an exem­plary fol­low­er of the Ger­many-led aus­ter­i­ty mod­el. The cen­ter-right gov­ern­ment at the time, led by Prime Min­is­ter Pedro Pas­sos Coel­ho, cut pub­lic employ­ees’ wages, raised tax­es and slashed spend­ing to bal­ance its accounts. The bud­get deficit fell sharply, from close to 10% of gross domes­tic prod­uct in 2010 to 3% of GDP last year, exclud­ing a cap­i­tal injec­tion into a failed lender.”

And despite being con­sid­ered an exem­plary fol­low­er of Ger­many-led aus­ter­i­ty, Por­tu­gal’s econ­o­my is still so frag­ile that a sin­gle cred­it rat­ing down­grade could kick it out of the ECB’s QE program...a pro­gram designed to help the euro­zone’s weak­est economies. Isn’t the euro­zone fun?

For­tu­nate­ly for Por­tu­gal, DBRS — the last cred­it rat­ing agency left in the world that gives Por­tu­gal’s debt an invest­ment grade rat­ing — did reaf­firm Por­tu­gals cred­it rat­ing back in April. And did so again in Octo­ber [12]. So, for now, Por­tu­gal is still able to par­tic­i­pate in the QE pro­gram that is vital to its eco­nom­ic recov­ery. But just bare­ly.

And as we saw above, there’s still the issue of less Por­tuguese bonds being bought under the QE pro­gram than the “cap­i­tal key” war­rants due to con­cerns over the coun­try hit­ting that 33 per­cent cap before the QE pro­gram final­ly winds down. So even if ECB extends the QE pro­gram past its March 2017 dead­line, the ques­tion of how Por­tu­gal would get around these bar­ri­ers remained.

The ECB’s Dis­ap­point­ing Sep­tem­ber. And Ter­ri­fy­ing Taper Talk in Octo­ber

And what did the ECB even­tu­al­ly decide to do with Ger­many run­ning out of eli­gi­ble bonds and coun­tries like Por­tu­gal and Ire­land hit­ting their 33 per­cent cap? Well, also keep in mind that the cur­rent round of the ECB’s QE pro­gram is sched­uled to expire in March of 2017. So with a num­ber of euro­zone economies still in dan­ger­ous­ly frag­ile ter­ri­to­ry the expec­ta­tion back in Sep­tem­ber was that, at a min­i­mum, the ECB was going to announce an exten­sion of its QE pro­gram past March 2017 dur­ing is meet­ing on Sep­tem­ber 8th. And, or course, that did­n’t hap­pen, despite a cut in the esti­mat­ed eco­nom­ic growth fore­cast [13]:

CNBC

ECB sur­pris­es by fail­ing to extend QE dead­line; cuts euro zone growth fore­casts

Katy Bar­na­to
Thurs­day, 8 Sep 2016 | 9:06 AM ET

The Euro­pean Cen­tral Bank (ECB) sur­prised mar­kets on Thurs­day by fail­ing to extend the dead­line for its tril­lion-euro bond-buy­ing pro­gram.

Expec­ta­tions were high the cen­tral bank would pro­long­ing the pro­gram beyond its cur­rent dead­line of March 2017, but it did not do so.

The euro zone STOXX 50 index fell on the news, but the euro rose slight­ly against the U.S. dol­lar to near a two-week high. The yields on Ger­man bench­mark 10-year Bunds turned slight­ly less neg­a­tive.

ECB Pres­i­dent Mario Draghi said the cen­tral bank did not dis­cuss extend­ing the pro­gram at its lat­est mon­e­tary pol­i­cy meet­ing.

“Our pro­gram is effec­tive and we should focus on its imple­men­ta­tion,” he said at his reg­u­lar post-deci­sion media con­fer­ence on Thurs­day.

The ECB held its key inter­est rates unchanged on Thurs­day, as expect­ed. The rate on the ECB’s mar­gin­al lend­ing facil­i­ty stands at 0.25 per­cent, with the rate on the deposit facil­i­ty at ‑0.4 per­cent. The fixed rate on the ECB’s main refi­nanc­ing oper­a­tions remains at zero. The ECB last moved rates in March, when it cut the rate on the mar­gin­al lend­ing facil­i­ty by 5 basis points.

Despite the ECB’s mon­e­tary stim­u­lus pro­gram — which includes low or neg­a­tive rates, low-inter­est loans to banks and a tril­lion-euro bond-buy­ing pro­gram — the euro zone’s eco­nom­ic growth and infla­tion rate remain stub­born­ly low.

On Thurs­day, the cen­tral bank raised its eco­nom­ic growth out­look for the euro zone slight­ly for 2016, but cut it for 2017 and 2018. It now sees growth in the 19-coun­try bloc aver­ag­ing 1.7 per­cent this year, hav­ing pre­vi­ous­ly fore­cast 1.6 per­cent growth. It fore­casts expan­sion of 1.6 per­cent in 2017 and 2018, down from its June fore­cast of 1.7 per­cent in both years.

The cen­tral bank’s 2016 infla­tion fore­cast was held at 0.2 per­cent and its 2018 esti­mate stayed at 1.6 per­cent. How­ev­er, it cut its 2017 fore­cast to 1.2 per­cent from 1.3 per­cent.

“We will pre­serve the very sub­stan­tial amount of mon­e­tary sup­port that is embed­ded in our staff pro­jec­tions and that is nec­es­sary to secure a return to infla­tion,” Draghi said in his state­ment.

Draghi said the ECB’s mon­e­tary stim­u­lus would boost euro zone eco­nom­ic growth by 0.6 per­cent over the fore­cast hori­zon and infla­tion by 0.4 per­cent.

The euro zone’s econ­o­my is seen being ham­pered by slug­gish glob­al demand, due to sev­er­al fac­tors, includ­ing the U.K.‘s vote in June to quit the Euro­pean Union, he added.

The ECB’s infla­tion fore­casts are par­tic­u­lar­ly impor­tant, as the cen­tral bank has a sin­gle man­date to tar­get price sta­bil­i­ty. It aims for infla­tion of close to, but below 2 per­cent over the medi­um term. Aver­age infla­tion in the bloc, based on non-har­mo­nized nation­al con­sumer price index­es fell below 1.75 per­cent in March 2013, kept on falling, and is cur­rent­ly around 0.2 per­cent.

Pri­or to Thurs­day’s announce­ment, there was spec­u­la­tion the ECB might extend the dead­line on its quan­ti­ta­tive eas­ing pro­gram. The ECB has extend­ed the dead­line before, upped its month­ly asset-pur­chas­es of secu­ri­ties to 80 bil­lion euros ($90 bil­lion) from 60 bil­lion euros and expand­ed the pro­gram to include cor­po­rate bond-buy­ing.

Focus has now shift­ed to whether the ECB will announce an exten­sion to the pro­gram lat­er this year.

...

“On Thurs­day, the cen­tral bank raised its eco­nom­ic growth out­look for the euro zone slight­ly for 2016, but cut it for 2017 and 2018. It now sees growth in the 19-coun­try bloc aver­ag­ing 1.7 per­cent this year, hav­ing pre­vi­ous­ly fore­cast 1.6 per­cent growth. It fore­casts expan­sion of 1.6 per­cent in 2017 and 2018, down from its June fore­cast of 1.7 per­cent in both years.”

After low­er­ing its growth fore­casts for 2017 and 2018 slight­ly, ECB’s response back in Sep­tem­ber to the ques­tion of whether or not it’s going to extend the QE pro­gram past March: The ECB was­n’t sure. Check back lat­er in the year.

So that was the ECB’s posi­tion on the future of QE back in Sep­tem­ber. But by ear­ly Octo­ber anoth­er mes­sage start­ed ema­nat­ing from ECB pol­i­cy-mak­ing cir­cles: If the ECB decides to dis­con­tin­ue the QE pro­gram, don’t expect those month­ly ECB bond pur­chas­es to end sud­den­ly. Instead, much like what the Fed­er­al Reserve did to even­tu­al­ly end its QE pro­gram, mar­kets should expect the end of the ECB QE’s to come in the form of a “taper” where the month­ly ECB bond pur­chas­es are steadi­ly low­ered to even­tu­al­ly zero. And while the idea of “taper­ing” the QE makes a lot of sense and isn’t all that notable, hav­ing anony­mous leaks to the press that the ECB was think­ing about “taper­ing” at a time when the euro­zone economies are still very frag­ile and every­one is won­der if the QE is going to be extend­ed at all was pret­ty notable. And alarm­ing [14]:

The Finan­cial Times

Why euro­zone bonds are rat­tled by taper talk

Germany’s 10-year Bund approach­ing a pos­i­tive yield for the first time in two weeks

by: Elaine Moore
Octo­ber 6, 2016

Euro­pean bond mar­kets are being rat­tled by talk that the Euro­pean Cen­tral Bank is con­sid­er­ing ways to call time on its €80bn-a-month bond-pur­chase pro­gramme before the March 2017 end date.

While the ECB has denied the reports, bonds across the euro­zone are sell­ing off — with Germany’s 10-year Bund yield on the cusp of turn­ing pos­i­tive for the first time in two weeks.

What’s rat­tling traders?

On Tues­day, Bloomberg pub­lished a sto­ry cit­ing unnamed sources who claimed that the ECB was think­ing of wind­ing down its bond pur­chas­es in steps of €10bn a month ahead of its plans for QE to end in March, trig­ger­ing an imme­di­ate jump in yields across bond mar­kets.

The ECB is adamant that QE taper­ing is not up for dis­cus­sion, with Michael Steen, head of media rela­tions at the ECB, tweet­ing that the “gov­ern­ing coun­cil has not dis­cussed these top­ics, as Draghi said at last press con­fer­ence and dur­ing tes­ti­mo­ny at the Euro­pean Par­lia­ment”.

Is this a taper tantrum?

Taper is not a word finan­cial mar­kets like to hear. Bench­mark 10-year gov­ern­ment bond yields of Ger­many, France, Italy and Spain all jumped about 4 basis points in the space of an hour and have con­tin­ued to climb.

The moves illus­trate how depen­dent investors have become on mass bond-buy­ing pro­grammes from cen­tral banks in Europe, the UK and Japan — but so far this sell-off does not com­pare with the “taper tantrum” trig­gered in 2013 by the US Fed­er­al Reserve plans to slow down its QE pur­chas­es.

Yields on Germany’s 10-year Bund — a proxy for wider Euro­pean mar­kets — are up a few basis points not per­cent­age points and remain far low­er on the year.

What do investors think?

Bond strate­gists and fund man­agers seem torn between sus­pi­cion that there is no smoke with­out fire and con­vic­tion that with euro­zone infla­tion still low, any talk of taper­ing seems pre­ma­ture.

JPMor­gan notes that views attrib­uted to anony­mous “sources” should be viewed with cau­tion, not­ing that end­ing QE and rais­ing inter­est rates would be dif­fi­cult with infla­tion at cur­rent rates.

In fact, falling bond yields in recent months sug­gest investors had been expect­ing the ECB to relax its self-imposed lim­its and expand the uni­verse of assets it can buy in order to address scarci­ty in the euro­zone gov­ern­ment bonds eli­gi­ble for QE.

Fred­erik Ducrozet at Pictet has anoth­er idea. Per­haps, he says, con­ver­sa­tions about taper­ing are being used to soft­en up ECB gov­ern­ing coun­cil mem­bers who oppose an exten­sion of the pro­gramme — such as Jens Wei­d­mann, head of the Bun­des­bank.

“The leaks could also be a super­fi­cial con­ces­sion to the hawks ahead of a deci­sion to extend QE,” he says. “A way to reas­sure them that an exit plan for QE exists, even if it is enlarged in the short term.”

...

What will hap­pen next?

The next meet­ing of the ECB’s gov­ern­ing coun­cil is on Octo­ber 27 but pol­i­cy­mak­ers are not expect­ed to make a deci­sion on QE until lat­er in the year, after the infla­tion fore­cast for 2019 is pub­lished. If infla­tion looks as though it will con­tin­ue to under­shoot then the case for QE exten­sion will be stronger.

Andrew Bosom­worth, Pimco’s head of port­fo­lio man­age­ment in Ger­many, says QE must end at some point, but points out that it will be a del­i­cate bal­anc­ing act.

“It will be dif­fi­cult for the ECB to stop QE with­out there being an impact on bond yields,” he says. “And the ECB has to be care­ful to nav­i­gate the exit in such a way that yields do not rise to such lev­els that indebt­ed coun­tries have dif­fi­cul­ty — some­thing that could reignite the threat of anoth­er euro­zone sov­er­eign debt cri­sis.”

“Bond strate­gists and fund man­agers seem torn between sus­pi­cion that there is no smoke with­out fire and con­vic­tion that with euro­zone infla­tion still low, any talk of taper­ing seems pre­ma­ture.”

Yeah, it’s hard to see why talk of a how the ECB might “taper” the QE pro­gram would­n’t spook the mar­kets. But the rea­son such talk would spook the mar­kets — the rea­son being that the euro­zone economies are still dan­ger­ous­ly frag­ile and end­ing QE pre­ma­ture­ly could be a dis­as­ter — also hap­pens to be the rea­son such talk is hard to inter­pet. Because taper­ing the QE makes absolute­ly no sense in the cur­rent con­text. And yet such talk did report­ed­ly take place, at least accord­ing to anony­mous sources, although the ECB denied the reports.

The ECB’s Less Than Enthu­si­as­tic Response to Trump in Novem­ber

So what did the ECB final­ly decide to do about the future of the QE pro­gram dur­ing its Decem­ber 8th meet­ing? Well, before we get to that, note that there was anoth­er rather sig­nif­i­cant event that took place recent­ly that would also rea­son­ably impact the ECB’s deci­sion-mak­ing regard­ing the future of QE: the elec­tion of Don­ald Trump. And based on the com­ments com­ing from the ECB offi­cials in the weeks fol­low­ing Trump’s win, despite the expec­ta­tions of ris­ing infla­tion and the talk of a new US fis­cal stim­u­lus pro­gram, the ECB offi­cials did­n’t appear to see a Trump admin­is­tra­tion as like­ly help­ful for the euro­zone. And pos­si­bly very unhelp­ful [15]:

Reuters

ECB fears pop­ulist back­lash after Trump’s win: sources

By Francesco Canepa and Bal­azs Koranyi | FRANKFURT
Fri Nov 18, 2016 | 10:13am EST

Euro­pean Cen­tral Bank offi­cials are grow­ing increas­ing­ly wor­ried that Don­ald Trump’s vic­to­ry in the U.S. pres­i­den­tial race may harm the euro zone by hurt­ing trade with the Unit­ed States and fuelling pop­ulism.

Speak­ing pub­licly and behind the scenes, ECB offi­cials empha­sise any U.S. shift towards pro­tec­tion­ism under Trump could hurt the already frag­ile euro zone econ­o­my and pave the way for an even stronger back­lash against glob­al­i­sa­tion and the euro project.

This could hin­der the ECB’s efforts to revive growth and infla­tion in the euro zone just as the eco­nom­ic pic­ture was start­ing to look less bleak.

If they only looked at finan­cial mar­kets, ECB rate set­ters should be mod­er­ate­ly pleased: euro zone infla­tion expec­ta­tions, bond yields and stocks have all gone up since Trump’s vic­to­ry, show­ing investors are bet­ting on spend­ing-led stronger U.S. eco­nom­ic growth.

In addi­tion, high­er bond yields have eased imme­di­ate con­cerns the ECB may run out of Ger­man debt to buy in its 1.74 tril­lion euros asset-pur­chase pro­gramme, the cen­tre-piece of its stim­u­lus strat­e­gy.

How­ev­er, top offi­cials stress the sit­u­a­tion is far more com­plex than this and the ECB still looks still set to announce an exten­sion of its bond buy­ing beyond their March dead­line at the bank’s Dec. 8 meet­ing.

First, ris­ing bor­row­ing costs for indebt­ed periph­er­al gov­ern­ments show that investors are pric­ing in ris­ing polit­i­cal risk in the euro zone as anti-glob­al­i­sa­tion and euroscep­tic voic­es are embold­ened by Trump’s win, which came hard on the heels of the Brex­it vote.

This was par­tic­u­lar­ly vis­i­ble in Italy where the gov­ern­men­t’s bor­row­ing costs were on track on Fri­day for their biggest two-week rise since the 2012 debt cri­sis and bank­ing stocks fell ahead of a Dec. 4 ref­er­en­dum that could unseat pro-euro Prime Min­is­ter Mat­teo Ren­zi.

“The over­all (mar­ket) sig­nal is not clear cut,” a cen­tral bank offi­cial said, stress­ing it was still too ear­ly to con­sid­er any coun­ter­move.

Sec­ond, Vice Pres­i­dent Vitor Con­stan­cio has warned that any fis­cal eas­ing in the Unit­ed States — such as Trump’s planned infra­struc­ture spend­ing — may not ben­e­fit the euro zone if the new U.S. admin­is­tra­tion sticks to its ‘Amer­i­ca first’ pledge, hurt­ing Europe’s exports to its biggest trad­ing part­ner.

Even a hawk­ish mem­ber of the ECB’s Exec­u­tive Board, Yves Mer­sch, warned that growth in the euro zone was still “frag­ile” and the infla­tion pick-up not yet sus­tain­able.

This was fur­ther empha­sised by Pres­i­dent Mario Draghi, who said on Fri­day the recov­ery relied on con­tin­ued mon­e­tary sup­port from the ECB.

Both Mer­sch and Draghi also warned that rolling back finan­cial reg­u­la­tion could pave the way for a repeat of the 2008 cri­sis, a thin­ly veiled ref­er­ence to Trump’s cam­paign promise to ease those rules.

Mean­while, con­fi­dence remains low that euro zone gov­ern­ments will heed the ECB’s long-stand­ing call for greater fis­cal spend­ing in sur­plus coun­tries such as Ger­many, despite a Euro­pean Com­mis­sion’s plea for loos­er strings this week.

“In prin­ci­ple, we wel­come any pro­pos­al for growth sup­port­ive fis­cal pol­i­cy,” Mer­sch told Reuters this week. “But we have not seen the details and there have been some dis­ap­point­ments in this regard in the past.”

...

“Speak­ing pub­licly and behind the scenes, ECB offi­cials empha­sise any U.S. shift towards pro­tec­tion­ism under Trump could hurt the already frag­ile euro zone econ­o­my and pave the way for an even stronger back­lash against glob­al­i­sa­tion and the euro project.”

Well, that cer­tain­ly sounds like a Trump vic­to­ry would make the ECB more, not less, like­ly to announce an exten­sion of the extend the QE dur­ing its Decem­ber 8th meet­ing. And giv­en that ris­ing bond yields in response to Trump’s vic­to­ry increased the num­ber of Ger­man bonds above ‑0.4 per­cent, more bonds will be avail­able for the ECB to pur­chase and, one might assume, the ECB would be less like­ly to pur­sue the option of low­er­ing the min­i­mum bond yield the ECB can pur­chase below that ‑0.4 thresh­old.

The ECB’s Very Dis­ap­point­ing Decem­ber. Very Vague­ly Dis­ap­point­ing

So let’s take a moment to sum­ma­rize the ECB’s QE conun­drum this year:

1. The QE pro­gram was expand­ing back in March from 60 bil­lion to 80 bil­lion euros in bond pur­chas­es each month, reflect­ing per­sis­tent near-defla­tion and weak economies.

2. The cur­rent QE pro­gram is sched­ule to end in March of 2017, despite the fact that the euro­zone infla­tion lev­els are close to 0 per­cent and its economies remain extreme­ly weak.

3. The ECB’s QE pro­gram has sev­er­al self-imposed rules that deter­mine which bonds, and in what vol­umes, the ECB can pur­chase and because of those rules and the lack of Ger­man bonds above a ‑0.4 per­cent yield, a sit­u­a­tion was approach­ing were QE pro­gram could­n’t con­tin­ue with­out break­ing those rules.

4. Ire­land and Por­tu­gal were also hit­ting a QE wall due to the QE rules that caps the total ECB bond hold­ings to 33 per­cent for a giv­en coun­try and had already reduced their QE bond pur­chas­es below what the “cap­i­tal key” allowed because of this.

5. If Por­tu­gal’s bond rat­ing is cut by the last remain­ing cred­it rat­ing agency to give it an invest­ment-grade rat­ing, Por­tu­gal is out of the QE and back into “bailout” aus­ter­i­ty ter­ri­to­ry.

6. Head­ing into the ECB’s Sep­tem­ber 8th meet­ing, the mar­kets were expect an announce­ment of an exten­sion of the QE pro­gram past March. That did­n’t hap­pen. Although a cut in the eco­nom­ic growth fore­cast did hap­pen.

7. In ear­ly Octo­ber, reports that the ECB was already engag­ing in “taper talk” con­fused and spooked the mar­kets.

8. And, final­ly, fol­low­ing the elec­tion of Don­ald Trump, ECB offi­cials made it clear that they saw this as increas­ing­ly, not decreas­ing, the risks for the euro­zone economies.

And giv­en all that, did the ECB final­ly drop the “cap­i­tal key” or the 33 per­cent cap like most experts rec­om­mend­ed so it could stop buy­ing Ger­man bonds (dri­ving yields deep­er into neg­a­tive ter­ri­to­ry) and focus on weak­er economies? Of course not. Instead, it cut the min­i­mum deposit rate to below ‑0.40 so it could find more eli­gi­ble Ger­man bonds. And also cut the total ECB month­ly QE bond pur­chas­es by 25 per­cent, a move wide­ly inter­pret­ed as the start of a much-feared pre­ma­ture “taper” [16]:

The Wall Street Jour­nal

ECB Extends but Scales Back Stim­u­lus, Whip­saw­ing Mar­kets
Bank’s move to buoy Europe’s econ­o­my comes days before Fed is expect­ed to raise inter­est rates in U.S.

By Tom Fair­less
Updat­ed Dec. 8, 2016 3:07 p.m. ET

FRANKFURT—The Euro­pean Cen­tral Bank pro­longed its extra­or­di­nary life­line to weak euro­zone economies on Thurs­day, just days before the U.S. Fed­er­al Reserve is expect­ed to move in the oppo­site direc­tion and raise inter­est rates.

That diver­gence, along with dif­fi­cul­ty in read­ing the nuances of the ECB’s action, caused investors to ini­tial­ly boost the euro before send­ing it low­er as U.S. equi­ty mar­kets hit record highs.

The ECB sur­prised mar­kets by say­ing it would slow the pace of its asset pur­chas­es, spark­ing a debate over whether the ECB had start­ed down the path toward end­ing its mon­e­tary stim­u­lus. Such a move—swiftly denied by the ECB—might be wel­comed by some of the bank’s top offi­cials, who are eager to sig­nal an even­tu­al exit.

Instead, the ECB’s deci­sion was most­ly tak­en as a sign the euro­zone bad­ly needs the type of sup­port that the Fed next week could begin remov­ing from the U.S., amid evi­dence and expec­ta­tions of sol­id eco­nom­ic growth there.

...

The ECB said on Thurs­day it would extend its so-called quan­ti­ta­tive eas­ing pro­gram by nine months, until at least the end of next year, tak­ing its total size above €2.2 tril­lion ($2.36 tril­lion). But start­ing in April, the bank will reduce the val­ue of secu­ri­ties it buys per month to €60 bil­lion from €80 bil­lion.

Investors had con­sid­ered such a move unlike­ly, bet­ting that the ECB would con­tin­ue to buy bonds at the cur­rent pace for at least anoth­er six months. Finan­cial mar­kets ini­tial­ly react­ed neg­a­tive­ly, with the price of shares and bonds falling sharply, and the euro ris­ing against the dol­lar. Mar­kets lat­er reversed much of that fall.

The ECB’s deci­sion to slight­ly lift its foot off the gas, as some saw it, comes despite slug­gish growth and mount­ing polit­i­cal uncer­tain­ty across the 19-nation euro­zone, which faces a string of major elec­tions next year and fall­out from Italy’s rejec­tion of con­sti­tu­tion­al changes ear­li­er this week. The move is like­ly to have been backed by some hawk­ish mem­bers of the cen­tral bank’s 25-mem­ber gov­ern­ing coun­cil, who have ear­li­er sig­naled they seek a clear path out of the bank’s easy-mon­ey poli­cies.

...

ECB Pres­i­dent Mario Draghi took pains at a press con­fer­ence Thurs­day to stress that the bank’s deci­sion didn’t amount to taper­ing, or wind­ing down, the bank’s stim­u­lus. He warned that infla­tion in the euro­zone remained too weak and said the ECB would keep buy­ing bonds for some time.

“There is no ques­tion about taper­ing,” Mr. Draghi said. “Taper­ing has not been dis­cussed today.”

...

Mas­sive cen­tral-bank buy­ing has helped buoy mar­kets in recent years, and investors keep buy­ing on the belief that such stim­u­lus will con­tin­ue. But more recent­ly, investors have debat­ed whether the ECB would begin to taper its aid in light of a rosier eco­nom­ic pic­ture and con­cerns over poten­tial side effects of its his­tor­i­cal­ly loose mon­e­tary pol­i­cy.

On Thurs­day, investors decid­ed the ECB, for now, wasn’t look­ing to turn off the taps.

...

Still, many investors weren’t con­vinced by Mr. Draghi’s argu­ments. At times on Thurs­day, the ECB chief veered into seman­tic gym­nas­tics in an appar­ent effort to avoid the kind of “taper tantrum” seen in the U.S. in 2013, when the Fed sug­gest­ed it might wind down its own bond-pur­chase pro­gram.

True taper­ing, Mr. Draghi argued, would involve grad­u­al­ly reduc­ing the pace of bond pur­chas­es to zero. That move wasn’t dis­cussed “and is not even on the table,” he said.

“This was a taper, as much as [Mr. Draghi] wants to deny it,” said Tim Graf, Euro­pean head of macro strat­e­gy at State Street in Lon­don. But Mr. Graf wel­comed said the ECB’s deci­sion to extend its pur­chas­es for longer than expect­ed would post­pone any fresh debate on the QE pro­gram until after key Euro­pean elec­tions next year.

“The big Christ­mas present was time,” Mr. Graf said.

Mr. Draghi said the ECB’s deci­sion had received “very, very broad con­sen­sus” from the bank’s 25-mem­ber gov­ern­ing coun­cil. Top ECB offi­cials have been rais­ing con­cerns about the adverse side effects of the bank’s easy-mon­ey poli­cies. Bun­des­bank Pres­i­dent Jens Wei­d­mann, long an oppo­nent of the ECB’s bond pur­chas­es, vot­ed against Thursday’s deci­sion.

“This is a step in the right direc­tion,” said Clemens Fuest, pres­i­dent of Germany’s Ifo eco­nom­ic insti­tute, a promi­nent crit­ic of the ECB’s stim­u­lus poli­cies.

Michael Heise, chief econ­o­mist at Allianz SE in Munich, point­ed to the ECB’s state­ment that it could accel­er­ate its bond pur­chas­es again if need­ed. That “can’t be described as taper­ing,” Mr. Heise said.

Oth­ers were less con­vinced. “Today was a missed oppor­tu­ni­ty to pro­vide some sort of sup­port to the mar­ket into a very uncer­tain polit­i­cal cal­en­dar in 2017,” said Patrick O’Donnell, an invest­ment man­ag­er at Aberdeen Asset Man­age­ment [17].

The ECB also announced changes to the design of its QE pro­gram on Thurs­day, to ensure it can con­tin­ue to find enough bonds to buy. Mr. Draghi said that from Jan­u­ary the ECB could start buy­ing debt that yields below the minus 0.4% inter­est rate it pays on com­mer­cial bank deposits, some­thing its own rules had barred it from doing. That move was aimed at address­ing a scarci­ty of Ger­man bonds. And Mr. Draghi said that the ECB would start buy­ing bonds with matu­ri­ties of one year, down from the pre­vi­ous min­i­mum matu­ri­ty of two years.

The ECB also announced changes to the design of its QE pro­gram on Thurs­day, to ensure it can con­tin­ue to find enough bonds to buy. Mr. Draghi said that from Jan­u­ary the ECB could start buy­ing debt that yields below the minus 0.4% inter­est rate it pays on com­mer­cial bank deposits, some­thing its own rules had barred it from doing. That move was aimed at address­ing a scarci­ty of Ger­man bonds. And Mr. Draghi said that the ECB would start buy­ing bonds with matu­ri­ties of one year, down from the pre­vi­ous min­i­mum matu­ri­ty of two years.”

Yes, one of the worst options the ECB had for extend­ing its QE pro­gram — drop­ping the low­er lim­it on the bond yields it could pur­chase so it could find more Ger­man bonds to buy — is the option it end­ed up going with. And while Bun­des­bank pres­i­dent Jens Wei­d­mann vot­ed against the ECB’s deci­sion to extend the QE to the end of 2017, it’s hard to imag­ine that he was­n’t extreme­ly pleased by the over­all out­come. After all, the mar­kets were gen­er­al­ly expect­ing a QE exten­sion head­ing into that meet­ing. But they weren’t expect­ing the start of a QE taper too. Or some­thing that could be inter­pret­ted as the start of a taper. And if the pres­i­dent of Germany’s Ifo eco­nom­ic insti­tute thinks this was a “step in the right direc­tion”, jens Wei­d­mann would almost cer­tain­ly agree:

...
The ECB’s deci­sion to slight­ly lift its foot off the gas, as some saw it, comes despite slug­gish growth and mount­ing polit­i­cal uncer­tain­ty across the 19-nation euro­zone, which faces a string of major elec­tions next year and fall­out from Italy’s rejec­tion of con­sti­tu­tion­al changes ear­li­er this week. The move is like­ly to have been backed by some hawk­ish mem­bers of the cen­tral bank’s 25-mem­ber gov­ern­ing coun­cil, who have ear­li­er sig­naled they seek a clear path out of the bank’s easy-mon­ey poli­cies.
...

“This is a step in the right direc­tion,” said Clemens Fuest, pres­i­dent of Germany’s Ifo eco­nom­ic insti­tute, a promi­nent crit­ic of the ECB’s stim­u­lus poli­cies.

...

Now, keep in mind that ECB pres­i­dent Mario Draghi went to lengths to assure mar­kets that this was­n’t actu­al­ly the start of a true taper like Wei­d­mann or the rest of the pro-aus­ter­i­ty crowd would pre­fer. But also keep in mind that Draghi’s expla­na­tion for why this should­n’t be inter­pret­ted as the start of a taper — that a 25 per­cent cut in the month­ly bond pur­chas­es should­n’t be con­sid­ered the start of a taper because the cut was­n’t declared as part of an over­all plan to bring the month­ly asset pur­chas­es down to zero — isn’t exact­ly con­vinc­ing. Because while it’s cer­tain­ly pos­si­ble that the cut in month­ly bond pur­chas­es isn’t part of a secret­ly planned taper, it’s also the case that if the ECB want­ed to start the taper now, but did­n’t want to offi­cial­ly announce it and spook the mar­kets, doing some­thing like declar­ing this cut in bond pur­chas­es at the same time the ECB announces a 9 month exten­sion to the QE pro­gram — when the mar­kets were expect­ing a six month exten­sion [18] — is the kind of vague mixed mes­sag­ing we might expect from the ECB.

So it’s pos­si­ble we could be see­ing the stealth start of a real taper. Or maybe Draghi was sin­cere where he said the ECB is ready to expand the QE pro­gram as need­ed and tthe ECB’s announce­ment on Dec 8 was basi­cal­ly a tem­po­rary com­pro­mise between the hawks and doves. But also note the oth­er con­text the ECB’s deci­sion to announce a cut in the QE while also announc­ing a 9 month exten­sion of the QE pro­gram instead of the expect­ed 6 month exten­sion: If the ECB had announced a 6 month exten­sion, that would set the QE pro­gram to expire in Sep­tem­ber 2017 instead of Decem­ber 2017. And what’s hap­pen­ing between Sep­tem­ber and Decem­ber of 2017? Ger­many’s fed­er­al elec­tions in Octo­ber.

And it’s that con­text that rais­es the ques­tion of whether or not the ECB’s sur­prise deci­sions on Dec 8 to to cut asset pur­chas­es while extend­ing QE to the end of 2017 was basi­cal­ly all about try­ing to assuage ongo­ing Ger­man vot­er resis­tance to QE with a QE cut that looks like the start of a taper while also try­ing to avoid the need for the ECB to make a big new a pub­lic debate over what to do next debate with the QE. It would also help explain the deci­sion to find more bonds to pur­chase by low­er­ing the low­er lim­it on eli­gi­ble bond yields so the ECB can pur­chase more Ger­man bonds instead of oth­er options like drop­ping the “cap­i­tal key” which would have shift­ed the ECB’s focus away from a “QE that helpds every­one equal­ly” mod­el to a “QE that helps the coun­tries in need the most” mod­el.

Also don’t for­get that elec­tions in France and the Nether­lands are also sched­uled for next year and the far-right can­di­dates just might win in both cas­es. So, if euro­zone’s polit­i­cal zeit­gi­est goes hor­ri­bly awry next year, we could see the AfD surg­ing in Ger­many [19], Marine Le Pen win­ning in France [20], and Geert Wilder­s’s PVV dom­i­nat­ing the Nether­lands’ elec­tions in March [21]. Giv­en all that, it prob­a­bly would­n’t be too supris­ing if the ECB decid­ed to start sig­nal­ing a QE taper sim­ply to take to some of the polit­i­cal heat off the ECB in each of these loom­ing elec­tions in coun­tries where the far-right is on the rise. In oth­er words, it’s pos­si­ble the ECB craft­ed its Dec 8 announc­ment for its 2017 QE specif­i­cal­ly min­i­mize the inevitable politi­ciza­tion of QE that’s guar­an­teed to take place next year. And yes, doing that would, itself, be an act of politi­ciza­tion, but it would be an act of pre­emp­tive politi­ciza­tion designed to reduce an expect­ed future politi­ciza­tion of the ECB.

So was all that part of the ECB’s under­ly­ing log­ic for its Decem­ber 8 QE deci­sion? It sure seems pos­si­ble, and if so, it also rais­es the ques­tion of just what the ECB would be doing if it was bas­ing its deci­sions sole­ly on the eco­nom­ics of the sit­u­a­tion. And while we don’t get to know how the ECB would have act­ed under a dif­fer­ent polit­i­cal envi­ron­ment, also note that on the same day the ECB announced is extended/tapered QE plan, it also pro­vid­ed its for­cast for 2019. A fore­cast that once again pre­dicts that the ECB will miss its goal tar­get of hit­ting 2 per­cent infla­tion by 2019 [22]:

Reuters

ECB makes lit­tle change to growth and infla­tion fore­casts

Thu Dec 8, 2016 | 8:53am EST

The Euro­pean Cen­tral Bank left its eco­nom­ic growth and infla­tion fore­casts large­ly unchanged on Thurs­day, pre­dict­ing that price growth would raise slow­ly but again miss its tar­get of close to 2 per­cent in 2019.

The ECB slight­ly increased its 2017 growth fore­cast to 1.7 per­cent from 1.6 per­cent seen in Sep­tem­ber and lift­ed its 2017 infla­tion fore­cast to 1.3 per­cent from 1.2 per­cent pro­ject­ed three months ago, ECB Pres­i­dent Mario Draghi said at a news con­fer­ence.

In its ini­tial pro­jec­tions for 2019, the ECB put infla­tion at 1.7 per­cent, still below the tar­get it has under­shot for more than three years despite unprece­dent­ed stim­u­lus aimed at reviv­ing eco­nom­ic growth and boost­ing con­sumer prices.

...

“In its ini­tial pro­jec­tions for 2019, the ECB put infla­tion at 1.7 per­cent, still below the tar­get it has under­shot for more than three years despite unprece­dent­ed stim­u­lus aimed at reviv­ing eco­nom­ic growth and boost­ing con­sumer prices.”

Yes, for more than three years now, the ECB has failed to meet its 2 per­cent infla­tion tar­get and its pro­jec­tions for 2017–2019 con­tin­ue to under­shoot­ing that tar­get, fol­low­ing years of the ECB con­sis­tent­ly over­es­ti­mat­ing its infla­tion pro­jec­tions only to lat­er revise them low­er while mak­ing new over­ly opti­mistic expec­ta­tions [23]. But despite this track record, it’s worth point­ing out what the ECB did accom­plish with its unprece­dent­ed mon­e­tary stim­u­lus: avoid­ing the kind of out­right defla­tion that would make the euro­zone’s cur­rent eco­nom­ic woes look like a pic­nic. That’s some­thing. It could be worse.

The Unof­fi­cial De Fac­to Por­tuguese Taper

Still, while avoid­ing a defla­tion­ary death spi­ral is indeed a pos­i­tive achieve­ment it’s not an ade­quate achieve­ment. The euro­zone is just one shock away from that same defla­tion­ary death spi­ral. So if we real­ly are see­ing the ECB “set­tle” for fail­ing its 2 per­cent infla­tion tar­get indef­i­nite­ly — and that’s the mes­sage the ECB is send­ing when it issues a qua­si-taper on the same day its 2019 infla­tion pro­jec­tions con­tin­ue to fail to meet its that tar­get — that’s rather omi­nous. And, unfor­tu­nate­ly, for Por­tu­gal, the ECB’s announced QE plans are already look­ing rather omi­nous [24]:

Reuters

Por­tu­gal’s bor­row­ing costs move above cor­po­rates as ECB effect fades

* Por­tu­gal’s bor­row­ing costs move high­er than BB-rat­ed com­pa­nies
* QE changes favour short-dat­ed bonds from high­er-rat­ed coun­tries
* Pos­si­bil­i­ty of DBRS down­grade hangs “like sword of Damo­cles”

By Abhi­nav Ram­narayan
Tue Dec 20, 2016 | 8:41am EST

LONDON, Dec 20 Por­tu­gal’s bor­row­ing costs have risen above those of a group of sim­i­lar­ly-rat­ed Euro­pean com­pa­nies, on per­sis­tent con­cerns the Euro­pean Cen­tral Bank will strug­gle to buy Por­tuguese gov­ern­ment bonds after changes to its asset-pur­chase pro­gramme.

Gov­ern­ments tend to enjoy bet­ter bor­row­ing rates than com­pa­nies with sim­i­lar cred­it rat­ings as gov­ern­ment cred­it is seen as the least risky. All oth­er bor­row­ers pay a pre­mi­um.

This effect has been exac­er­bat­ed by the ECB’s bond-buy­ing scheme, launched in March 2015 and focused on gov­ern­ment debt. But last week the ECB made changes to the scheme that ana­lysts said would see pur­chas­es con­cen­trat­ed on high­ly-rat­ed bonds.

This graph­ic tmsnrt.rs/2hVdYBl [25] shows how over 2016 the yield on Por­tu­gal’s 10-year gov­ern­ment bond has, unusu­al­ly, risen above the yield on an index of Euro­pean cor­po­rates with the same rat­ing as the sov­er­eign.

Por­tu­gal 10-year bond, rat­ed Ba1/BB+/BB+ by the three main rat­ings agen­cies, is now 13 basis points (bps) above the Reuters index of 10-year dou­ble-B-rat­ed Euro­pean cor­po­rate bonds .

By com­par­i­son, Spain’s 10-year gov­ern­ment bond — rat­ed BBB — yields 25 bps less than an index of triple B‑rated bonds and A‑rated Ire­land’s 10-year bond yields 43 bps less than the single‑A index.

The ECB also buys invest­ment-grade cor­po­rate bonds under its asset-pur­chase scheme, albeit in much small­er vol­umes.

Por­tu­gal is also rat­ed BBB (low) by DBRS, the only agency to make the sov­er­eign invest­ment grade. It main­tained the rat­ing in Octo­ber.

“To me (the rever­sal) shows that the ECB sup­port for Por­tu­gal is no longer the same and it is now trad­ing more accord­ing to its rat­ing,” said Com­merzbank strate­gist David Sch­nautz.

“The changes to the ECB’s bond-buy­ing pro­gramme leave Por­tu­gal hang­ing because they don’t address the spe­cif­ic prob­lems Por­tu­gal faces in terms of QE eli­gi­bil­i­ty,” he said.

Last week’s changes will allow the ECB to buy bonds with matu­ri­ties of less than two years and bonds yield­ing less than the deposit rate.

Both changes imply the ECB will con­cen­trate its pur­chas­es on high­er-rat­ed coun­tries and not on the likes of Por­tu­gal, which has a lim­it­ed amount of short-dat­ed debt and no bonds yield­ing less than the minus 40 basis point deposit rate.

...

“This effect has been exac­er­bat­ed by the ECB’s bond-buy­ing scheme, launched in March 2015 and focused on gov­ern­ment debt. But last week the ECB made changes to the scheme that ana­lysts said would see pur­chas­es con­cen­trat­ed on high­ly-rat­ed bonds.

So despite the fact that Por­tu­gal and Ire­land were already devi­at­ing from the QE “cap­i­tal key” rule and buy­ing few­er bonds than their the cap­i­tal key war­rant­ed due to con­cerns over the QE 33 per­cent cap rule, the ECB decid­ed to low­er the min­i­mum yields on QE-pur­chased bond (so it could buy more Ger­man bonds with­out break­ing the cap­i­tal key for Ger­many) and not drop the cap­i­tal keys or the 33 per­cent cap to make more of Por­tu­gal’s bonds avail­able. And as ana­lysts observe, this all indi­cates that the ECB is going to be con­cen­trat­ing its QE bond pur­chas­es on high­ly-rat­ed bonds even though the whole point of some like QE is to shore up weak­er bond mar­kets and give them time and room to heal:

...
Por­tu­gal is also rat­ed BBB (low) by DBRS, the only agency to make the sov­er­eign invest­ment grade. It main­tained the rat­ing in Octo­ber.

“To me (the rever­sal) shows that the ECB sup­port for Por­tu­gal is no longer the same and it is now trad­ing more accord­ing to its rat­ing,” said Com­merzbank strate­gist David Sch­nautz.

“The changes to the ECB’s bond-buy­ing pro­gramme leave Por­tu­gal hang­ing because they don’t address the spe­cif­ic prob­lems Por­tu­gal faces in terms of QE eli­gi­bil­i­ty,” he said.

Last week’s changes will allow the ECB to buy bonds with matu­ri­ties of less than two years and bonds yield­ing less than the deposit rate.

Both changes imply the ECB will con­cen­trate its pur­chas­es on high­er-rat­ed coun­tries and not on the likes of Por­tu­gal, which has a lim­it­ed amount of short-dat­ed debt and no bonds yield­ing less than the minus 40 basis point deposit rate.
...

Both changes imply the ECB will con­cen­trate its pur­chas­es on high­er-rat­ed coun­tries and not on the likes of Por­tu­gal, which has a lim­it­ed amount of short-dat­ed debt and no bonds yield­ing less than the minus 40 basis point deposit rate.”

So the ECB’s lat­est QE changes appear to be ori­ent­ed to allow­ing it to buy more Ger­man bonds and less Por­tugese bonds. And absolute­ly noth­ing was done about the issue of Por­tu­gal approach­ing that 33 per­cent cap. In oth­er words, the ECB’s deci­sion to ori­ent its bond pur­chas­es away from Por­tu­gal is very much aligned with its deci­sion to do noth­ing about that 33 cap: while it’s unclear if the over­all QE pro­gram is about to under­go a taper, it’s more more clear for Por­tu­gal: Por­tu­gal’s QE par­tic­i­pa­tion is get­ting tapered one way or anoth­er.

All in all, whether or not the ECB is start­ing a QE taper for real or just for the­atrics to pla­cate anx­ious elec­torates, the motive for that move prob­a­bly has a lot more to do with the euro­zone’s polit­i­cal cir­cum­stances vs the macro­eco­nom­ic need for more QE. And if that is the case and there real­ly is con­cern at the ECB that its QE pro­grams could become focal point for anti-euro­zone par­ti­san ire in the upcom­ing elec­tions, per­haps it would be worth point­ing out to those angry elec­torates, espe­cial­ly the elec­torate in Ger­many, that the rules the ECB pre­vi­ous­ly put in place to ensure that QE would­n’t help one coun­try more than anoth­er (like the “cap­i­tal keys” and “no more than 33 per­cent of a nation’s sov­er­eign bonds can be held by the ECB” rules) has result­ed in a sit­u­a­tion where the coun­tries most in need of QE sup­port get the least. And vice ver­sa [26]:

The Wall Street Jour­nal

ECB’s New Dilem­ma: Need­i­est Nations Receive Less Stim­u­lus
Part­ly due to bank’s rules, its bond-buy­ing has under­shot Por­tu­gal and Ire­land

By Jon Sin­dreu
Dec. 19, 2016 6:00 a.m. ET

When it extend­ed its bond-pur­chase pro­gram this month, the Euro­pean Cen­tral Bank need­ed to choose between buy­ing bonds at extreme­ly neg­a­tive returns or gear­ing stim­u­lus toward euro­zone nations that need it the most.

It chose the for­mer.

Every move by pol­i­cy mak­ers in the sin­gle-cur­ren­cy euro­zone is sup­posed to avoid ben­e­fit­ing some nations over oth­ers. But now, due in part to the design of ECB rules, more stim­u­lus is deliv­ered to the health­i­est economies and less to those that are lag­ging behind.

This month, ECB Pres­i­dent Mario Draghi said the bank would extend the cen­tral bank’s asset-pur­chase pro­gram from its pro­ject­ed March end date until Decem­ber 2017. This change has forced offi­cials to relax the rules guid­ing the pro­gram to avoid run­ning out of eli­gi­ble bonds to buy.

The cen­tral bank has been man­dat­ed to spread its pur­chas­es accord­ing to how much cap­i­tal each coun­try has at the ECB. Keep­ing this quo­ta intact has been a goal for politi­cians in North­ern Europe, chiefly Ger­many, as it helps ensure coun­tries don’t have to share the debt bur­dens of oth­ers through the cen­tral bank.

How­ev­er, the ECB already bought debt of the eurozone’s most dis­tressed nations under an emer­gency pro­gram from 2010 to 2012 and is now hav­ing to buy less from these coun­tries than nation­al quo­tas would dic­tate.

This is because the ECB had two oth­er main self-imposed rules con­strain­ing its actions. First, it isn’t allowed to own more than one-third of a sin­gle issuer’s out­stand­ing debt. Sec­ond, it couldn’t buy bonds with yields below its own deposit-facil­i­ty rate, cur­rent­ly at minus 0.4%.

As a result, since it expand­ed bond buy­ing in March, the ECB has under­shot Por­tuguese bond pur­chas­es by well over €3 bil­lion ($3.1 bil­lion) and over­shot pur­chas­es in Ger­many by €8 bil­lion.

...

The aim of the bond-buy­ing pro­gram is to help the econ­o­my by low­er­ing bor­row­ing costs fur­ther, and Por­tu­gal clear­ly needs it more: Its 10-year gov­ern­ment yield is almost at 4%, sec­ond only to that of Greece, reflect­ing a founder­ing econ­o­my. In Ger­many, a coun­try at full employ­ment, the 10-year yield is close to 0.3%.

But the cen­tral bank’s deci­sions this month did lit­tle to address con­cerns that it will keep under­shoot­ing pur­chas­es in the need­i­est nations.

“We don’t think the ECB announce­ment is good for the periph­ery,” said Bert Louren­co, head of rates strat­e­gy for Europe, Mid­dle East and Asia at British lender HSBC Hold­ings PLC.

To expand the pool of eli­gi­ble assets, offi­cials chose to remove the pro­hi­bi­tion to buy bonds below the minus‑0.4% deposit rate, which will allow the ECB to buy more Ger­man and Dutch bonds. They didn’t touch any of the main obsta­cles that are dri­ving the cen­tral bank to buy less in Por­tu­gal and Ire­land.

The rea­son, Mr. Draghi said, is that “there was an increas­ing aware­ness of the legal and insti­tu­tion­al con­straints that would make such a change dif­fi­cult.”

The deci­sion isn’t pain­less for Ger­many, either. When the ECB buys a bond yield­ing, for exam­ple, minus‑0.5%, it does so by cre­at­ing a deposit in its own accounts. If the rate it pays on this deposit is minus‑0.4%, it means it is get­ting less from the bond than it is pay­ing, expos­ing itself to loss­es.

In real­i­ty, nation­al cen­tral banks do most of the pur­chas­es at the ECB’s behest, and yields are only neg­a­tive in the safest euro­zone nations. In Ger­many, all bonds up to five years of matu­ri­ty return less than minus‑0.4%. This means that remov­ing this rule will hurt, most of all, the Ger­man Bundesbank’s prof­its.

Still, “the Ger­mans pre­fer to take the heat on their own pur­chas­es than to relax con­straints on the periph­ery,” said François Savary, chief investor at Gene­va-based advi­so­ry firm Prime Part­ners. “It’s a polit­i­cal choice.”

To be sure, these bonds may still prove prof­itable if rates go low­er in the future. And even if some spe­cif­ic bonds gen­er­ate paper loss­es, over­all pur­chas­es are unlike­ly to.

Also, the stim­u­lus ide­al­ly reach­es beyond bor­ders. Ger­mans, for exam­ple, may use low­er bor­row­ing costs to import more prod­ucts from Por­tu­gal.

But some investors see the inflex­i­bil­i­ty of the rules as anoth­er con­cern­ing sign of the polit­i­cal strug­gle of the euro­zone to stay togeth­er.

While prof­its and loss­es don’t the­o­ret­i­cal­ly mean much to cen­tral banks, they often do in prac­tice.

Bun­des­bank Pres­i­dent Jens Wei­d­mann spoke against the removal of the deposit floor ear­li­er in the year, while Ger­man economists—like Hans-Wern­er Sinn, pres­i­dent of the Ifo Insti­tute for Eco­nom­ic Research—have often sug­gest­ed all of the ECB’s actions end up hid­ing under-the-table bailouts for south­ern Euro­pean coun­tries.

Any step toward aim­ing mon­e­tary pol­i­cy at the need­i­est coun­tries has long been polit­i­cal­ly con­tro­ver­sial and chal­lenged in Ger­man and Euro­pean courts. Some fear these con­straints on the ECB could impair its abil­i­ty to deliv­er more stim­u­lus.

“Polit­i­cal con­straints appear to now be dom­i­nat­ing,” Bank of Amer­i­ca Mer­rill Lynch told its clients last week. “Come anoth­er large shock, the cen­tral bank would have lit­tle ammu­ni­tion left.”

“Every move by pol­i­cy mak­ers in the sin­gle-cur­ren­cy euro­zone is sup­posed to avoid ben­e­fit­ing some nations over oth­ers. But now, due in part to the design of ECB rules, more stim­u­lus is deliv­ered to the health­i­est economies and less to those that are lag­ging behind.

And that’s where we are with the ECB’s QE: the health­i­est economies get the great­est ben­e­fit while the coun­tries that most need that QE stim­u­lus are get­ting slow­ing pushed out of the pro­gram:

...
This month, ECB Pres­i­dent Mario Draghi said the bank would extend the cen­tral bank’s asset-pur­chase pro­gram from its pro­ject­ed March end date until Decem­ber 2017. This change has forced offi­cials to relax the rules guid­ing the pro­gram to avoid run­ning out of eli­gi­ble bonds to buy.

The cen­tral bank has been man­dat­ed to spread its pur­chas­es accord­ing to how much cap­i­tal each coun­try has at the ECB. Keep­ing this quo­ta intact has been a goal for politi­cians in North­ern Europe, chiefly Ger­many, as it helps ensure coun­tries don’t have to share the debt bur­dens of oth­ers through the cen­tral bank.

How­ev­er, the ECB already bought debt of the eurozone’s most dis­tressed nations under an emer­gency pro­gram from 2010 to 2012 and is now hav­ing to buy less from these coun­tries than nation­al quo­tas would dic­tate.

This is because the ECB had two oth­er main self-imposed rules con­strain­ing its actions. First, it isn’t allowed to own more than one-third of a sin­gle issuer’s out­stand­ing debt. Sec­ond, it couldn’t buy bonds with yields below its own deposit-facil­i­ty rate, cur­rent­ly at minus 0.4%.

As a result, since it expand­ed bond buy­ing in March, the ECB has under­shot Por­tuguese bond pur­chas­es by well over €3 bil­lion ($3.1 bil­lion) and over­shot pur­chas­es in Ger­many by €8 bil­lion.
...

“As a result, since it expand­ed bond buy­ing in March, the ECB has under­shot Por­tuguese bond pur­chas­es by well over €3 bil­lion ($3.1 bil­lion) and over­shot pur­chas­es in Ger­many by €8 bil­lion.”

That’s the sit­u­a­tion: Thanks to all the self-imposed rules the ECB put in place in order to avoid any pos­si­bil­i­ty that the QE pro­gram could end up help­ing one euro­zone coun­try more than anoth­er, large­ly at the behest of the euro­zone’s wealth­i­er mem­bers like Ger­many and the Nether­lands, the ECB’s QE is now more of a stim­u­lus pro­gram for Ger­many than coun­tries the like Por­tu­gal that actu­al­ly need it. Will that lit­tle fun-fact end up pen­e­trat­ing the far-right “pop­ulist” fer­vor bound to dom­i­nate the polit­i­cal scene in next year’s crit­i­cal euro­zone elec­tions? Prob­a­bly not, but it should [27].