European Central Bank's July 2016 Meeting Post-Mortem: What’s the Upshot of it All?

The general consensus from the market appears to be that the ECB is in ‘wait-and-see’ mode, after the governing council left policy unchanged and Draghi batted back inquiries as to the future course of monetary policy.

The ECB somewhat took markets by surprise on Thursday after sidestepping expectations that they would adopt a gloomy mien, and coming out with a spirited response which was - if not ‘upbeat’ exactly - then certainly not as pessimistic as had been forecast.

The main factor which drove up the value of the euro was Draghi’s opening statement in which he praised the “resilience” of markets in withstanding the shock of Brexit relatively well.

He went on to talk ‘constructively’ about the Eurozone banking system and how robust it was now in comparison with during the great recession.

In relation to the Italian banking crisis Draghi suggested there was a proviso in the EU rules governing state aid which allowed for intervention in ‘extreme’ circumstances, and implied that this might be the case, but that it was up to the European Commission to decide.

Draghi was keen to play down the severity of fears about the solvency of Italian banks, affirming that the problem was not one of, “solvency”, but “weak profitability.”

This comment seems to rule out the possibility of a further deposit rate cut in the near future, as this would reduce profitability still further.

A major drag on bank profitability are the vast number (200bn in Italy) of Non-Performing Loans (NPL’s) which generate no -  or very little cash – for the banks who are stuck with them.

Draghi, provided an optimistic roadmap for remedying the problem, however, with a cocktail of reformed bankruptcy legislation, a strong secondary market for distressed debt and various other measures.

Marco Valli, of Unicredit commented on the subject of NPL’s in a review note on the meeting published afterwards:

“He (Draghi) singled out four conditions for successful recognition and disposal of NPLs: a consistent supervisory role, a well-functioning secondary market for distressed assets, government intervention to improve bankruptcy legislation and collateral recovery, and a public backstop available in exceptional circumstances to avoid fire sales of NPLs.

In response to questions about policy and the settings for the QE programme, Draghi did not say the ECB would or wouldn’t be preparing to launch more stimulus, but came out with the same pat answer drawn from the opening statement, that, he would essentially be waiting for more data to come in to assess the impact on Brexit and whether it warranted response.

However, he added: “if warranted to act the governing council will use all the instruments available within its mandate.”

Uncredit’s Valli commented that although the ECB statement did not, “convey any sense of urgency” about act the central bank did say it remained, “ready, willing and able,” to pull the trigger if necessary.

There had been much talk before the meeting that the ECB might tinker with its criteria rules for buying sovereign debt in its QE programme, as German bonds were in danger of running out, and the largest share of bonds bought by the ECB are German, since each country has an allocated share based on its economic size.

However, there was no hints that this might be altered.

Further, another solution suggested for unlocking more supply of bonds was to increase the 33% cap of the share which the ECB could own of any single type of bond.

Again Draghi was vague and elusive in response.  

“The Governing Council discussion was very much about the broader picture and did not address technical  issues. When asked about possible changes to the QE rules, Draghi remained vague: the ECB proved able to adapt its purchase program to changing conditions in the past and will be able to do so in the future if needed. Changes to the capital-key framework of purchases were not discussed – although, when asked, Draghi did not explicitly rule them out either. All options appear to remain on the table in case the ECB starts facing scarcity problems.” Remarked Unicredit’s Valli .

Overall the ECB has shifted its stance from expecting to loosen monetary policy, with some analysts even foreseeing a cut in the deposit rate, to a much more neutral ‘wait and see’ mode.

Even so Unicredit’s Valli, still expects growth to be  impacted by Brexit and for this to weigh on the outlook for growth and prompt an extension of the QE programme by 6-months.

“Looking ahead, the mix of weaker growth, slightly lower inflation and increased risks to financial stability after Brexit will probably convince the ECB to extend QE for six months until at least September 2017. The announcement may come either in September or in December. We do not expect a deposit rate cut because its side effects may outweigh the benefits.”

As far as changing the settings for QE, Valli sees little chance of a change in the share of bonds bought for each country, but instead that the ECB may relax the 33% general limit for ECB holdings of a single bond type.