The ECB carrot is back

Below is an article from one of our key investment partners in relation to the news announced last week that the European Central Bank (ECB) has raised interest rates by 0.5% points, defying market expectations for an 0.25% point increase. The deposit rate is now at 0%. To put this into an historical context, for the first time in eight years, banks will not be penalised with negative rates for parking money with the ECB.

Yet it is important to remember, investors are predominantly interested in what the ‘peak’ interest rate will be, once the tightening cycle is completed.

Indeed, ECB President Christine Lagarde used a similar argument to deflect criticism that the central bank had erred by signalling a hike of no more than 0.25% by saying it was the peak that was all that mattered. Ms Lagarde implied, sharper rises now will allow for a lower peak further down the line. And importantly, simultaneously, she put forward a new monetary tool designed to contain sovereign bond spreads (yield differences between different countries) in the Eurozone – the Transmission Protection Instrument (TPI).

Country spreads have many of the characteristics of traditional corporate credit spreads. Credit spreads – the difference and risk premium between corporate and government bond yields – measure the difference in default probabilities. One important driver is always the level of rates. If the perception is that rapid action (on inflation now) can help dampen the peak in rates.

A similar rationale applies to the debt of peripheral Eurozone nations, some of which are facing substantially higher yields. The ECB has been aware of this for some time and is worried that rate rises could have a magnified effect on the economies of these nations. It’s that anxiety that has led to the announcement of its “anti-frag” tool.
Anti-fragmentation sounds scary, but this is technical jargon which is not obviously a description of what it actually does. The Transmission Protection Instrument (TPI) sounds more like a car insurance policy than a tenet of monetary policy.

Despite the ECB having taken some time to define its operational scope, it was a disappointment to be given no operational details. We have been provided with broad structural guidelines but no legal limitation on whose debt could be bought, nor details or levels on the amounts of those purchases.

Yet there was some indication of the constraints being applied to the TPI, which in spirit are similar to previous Eurozone macro programmes and serve to underline the conditionality of the support to be provided. The underlying motivation for the application of carrot and stick in the scheme is to encourage economic change in the countries being targeted. It’s fair to say that the success so far seen in taking this approach has been mixed at best.

In order to benefit from the TPI, a nation must not be subject to the EU’s Excessive Deficit Procedure (EDP) or the EU’s Excessive Imbalance Procedure, which the Commission uses to maintain the eurozone’s fiscal rules. Public debt policy must be “sustainable” and “sound”. In making these judgments, the ECB has said it will also take into account the views of other organisations, including the IMF.

The Economist weekly is taking a positive view of the advent of the TPI. It sees the ECB’s unlimited latitude as helping to alleviate worries about levels of debt, particularly given that the ECB was clear it could buy private sector assets. The ECB “has claimed unlimited discretion to define these terms for itself. Ms Lagarde says the ECB as an institution has sovereignty to determine the eligibility criteria itself, a word not often heard from the mouths of central bankers”.

In addition, “the ECB has therefore given itself the maximum room for manoeuvre in forestalling any repeat of the eurozone crisis, while handing to others the politically delicate task of deciding whether governments ‘fiscal policies are appropriate and their debt sustainable”.

The Economist sees that, in a crisis, the ECB will hand over to the European Commission the difficult political decision whether to place a country into the EDP. The Commission will be unlikely to want to inflame a politically and economically volatile situation. So yes, there may be a barrier for the Commission to commit a member state to an EDP procedure, but equally it seems, the TIP is meant to be a carrot for countries to keep running sound policies.

Within the corridors of the ECB in Frankfurt, there are few signs of a return to the bad old days of the Eurozone Debt Crisis of a decade ago. That period did the Eurozone absolutely no favours. Or, to put it another way, the current situation helps to demonstrate that the eurozone only works if all play roughly but by the rules, as there is no prospect of automatic large scale fiscal transfers between countries. The ECB is the victim of insufficient care and consideration being given to the initial creation of Europe’s monetary union, which means that the Eurozone inevitably falls back in into the lap of the ECB when crisis strikes.

To ensure there is wiggle room in the implementation of the TPI, the terms and conditions of the new scheme are intentionally the subject of interpretation. Some might call it “constructive ambiguity.” It means the policy will probably not be implemented to head off a crisis, but only to act after the fact. As Bank of France Governor Villeroy said this morning, ““We’ve clearly defined criteria and indicators that make it possible to be objective about a situation. But there’s no automatic and mechanical threshold for activation or exclusion – nothing will replace the judgment of the Governing Council”.

Following the announcement, the ECB stated that the current situation developing in Italy did not warrant any TPI action. The widening of Italy’s credit spreads recently has been worrying, but not catastrophic.

Still, the fact that spreads widened on the announcement probably indicates that the ECB needs to provide further clarity before another crisis strikes yet again. The traditional trajectory of modern Italian politics suggest a test will come soon, as any future government in Rome will have to pledge additional fiscal support for businesses and households if energy prices remain at current levels.

Meanwhile, the Euro has rallied this week. Immediately following the 0.5% rate rise announcement, it gained 0.5% only to slip back as markets indicated a slight sense of disappointment in the TPI. The single currency is likely to continue to be subjected to similar pressures while President Putin has the whip hand over Europe’s energy supplies.

This article is for information purposes only – should not be perceived as financial advice. We recommend you should always speak to a financial adviser before making any investment decisions.

Please note, past performance is not a reliable indicator to future returns. Your investment may fall as well as rise, and you may not get back what you put in.