December 10, 2018 / 7:18 AM / 10 months ago

R.I.P. quantitative easing: Five questions for the ECB

LONDON (Reuters) - Thursday could prove to be a historic moment for the European Central Bank, which is expected to formally bring its unprecedented 2.6 trillion euro ($2.95 trillion) stimulus scheme to an end.

The skyline with its financial district and the headquarters of the European Central Bank (ECB) are photographed in the early evening in Frankfurt, Germany, December 4, 2018. REUTERS/Kai Pfaffenbach/File Photo

But with the economy weakening, trade tensions darkening the outlook and headwinds still on the horizon in the shape of Italy and Brexit, financial markets are looking ahead to next year and just how the ECB will protect the bloc from a severe downturn.

With ECB chief Mario Draghi’s final news conference of the year likely to prove anything but dull, we take a look at some key questions on the radar for investors.

1. In what ways will the ECB address a weakening economy?

The ECB is likely to maintain that economic conditions remain strong enough to allow it to bring almost four years of quantitative easing (QE) to an end.

At the same time, it will have to address recent economic data: euro zone manufacturing activity expanded at its weakest rate in over two years in November; powerhouse economy Germany shrank in the third quarter for the first time since 2015 — the year the ECB launched QE.

Economists say the ECB is likely to trim rather than slash its growth forecasts, due out on Thursday and maintain, for now, an assessment that risks to the economy are “broadly balanced.”

“There is ample evidence that risks have indeed shifted to the downside relative to the ECB’s assessment from three or six months ago, but they could still resist the pressure for communication purposes, given that they will end net asset purchases at the same time,” said Pictet Wealth Management strategist Frederik Ducrozet.

(Graphic: Euro zone manufacturing activity expands at weakest in over 2 years: tmsnrt.rs/2RNL7QU)

2. Could the ECB change its guidance on interest rates?

Indeed, recent weeks have seen a sharp scaling back of rate-hike expectations in the face of weak data, trade war fears and volatile markets. Money market pricing suggests investors price roughly a 80 percent chance of a 10 basis point rate hike from the ECB next year, down from 100 percent last month.

Since June the ECB has maintained that it will keep interest rates unchanged well into next year and recent comments from policy makers suggest this will remain the case even as concern about the economic outlook grows.

“They may say they will raise rates at the end of the summer or end of 2019, but a lot can happen in that time,” said Guy Foster, head of research at wealth management firm Brewin Dolphin.

(Graphic: Money market curve: tmsnrt.rs/2RHfYi2)

3. Where is the long-awaited rise in core inflation?

Headline inflation has been above the ECB’s near 2 percent target for months now. But underlying inflation excluding food and energy prices continues to disappoint.

This so-called core measure — watched closely by the ECB — rose just 1.1 percent in November, down from 1.2 percent in October.

A key market gauge of long-term euro-zone inflation expectations EUIL5YF5Y=R meanwhile is hovering close to its lowest in over a year, dragged down by oil prices which have tumbled some 30 percent LCOc1 in the past two months.

Against this backdrop, a downgrade to ECB inflation forecasts is unlikely to be a surprise. The ECB may play up the economic boost from weak oil since the euro area is a net oil importer and cheaper crude lifts disposable income.

(Graphic: Core inflation continues to disappoint: tmsnrt.rs/2RBcCNE)

4. What will the ECB say about re-investments from maturing bonds?

Policymakers are leaning towards making only nuanced changes to how the bank reinvests cash from maturing bonds, including keeping the duration of purchases open, sources with knowledge of the discussion told Reuters in late November.

ECB Chief Economist Peter Praet said recently that markets were right to expect a more precise definition at the December meeting on reinvestments given that so far the ECB has said only that these will continue for an extended period.

Markets see reinvestments continuing for about two years after the first interest-rate hike and policymakers say they are comfortable with these expectations.

With quantitative easing set to end, reinvestments are poised to become an important policy tool — especially for bond markets were asset purchases have pinned down borrowing costs.

For an interactive version of the below chart, click here tmsnrt.rs/2Nqxh3Z.

(Graphic: ECB's QE redemption estimates: tmsnrt.rs/2NpEjpM)

5. Is it time to TLTRO?

Perhaps the time for a new round of cheap, multi-year loans to banks, known formally as Targeted Long-Term Refinancing Operations (TLTROs) is getting nearer.

Sources told Reuters last week that ECB policymakers are debating ways to wean the currency bloc of easy money, floating ideas such as a new kind of TLTRO and staggered rate increases.

Banks in Italy, Spain, Portugal and Greece still borrow more from the ECB, particularly via TLTROs, than they deposit. This meant cash-poor banks in these countries would need to rely on weekly ECB auctions for cash once TLTROs expire.

Because this would push up the rate at which banks lend to each other, which was currently anchored to the ECB’s sub-zero deposit facility, making borrowing more expensive for the rest of the economy, talk of a new round of TLTROs is growing.

Policymakers are open to discussing a new round of multi-year loans to banks next year, albeit on different terms than previous editions, the sources said.

Still, this discussion is just starting and a decision on this front is not expected on Thursday.

(Graphic: Euro zone excess liquidity components: tmsnrt.rs/2RHk35U)

Reporting by Dhara Ranasinghe; Additional reporting by Balazs Koranyi in FRANKFURT and Josephine Mason in LONDON; Grpahics by Ritvik Carvalho and Francesco Canepa"

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