When does the ECB run out of bonds to buy?

  • If the self-imposed constraints of the ECB’s quantitative easing programme are respected, we estimate that the ECB will run out of eligible German Bunds (and German state and agency debt) to buy by mid to late 2018. We see this as the perfect excuse the ECB has for an early tapering of QE, as the Eurozone recovery consolidates.

The ECB’s Quantitative Easing program, otherwise known as the Asset Purchase Program (APP), has often met with stiff opposition from some of the more conservative minded forces in Europe who see this as a threat to monetary and financial stability in countries that, in their view, do not need additional monetary stimulus over and above the record low interest rates they currently enjoy . They have a point, but, crucially, will the fact that the ECB may run out of eligible bonds to buy in the not too distant future do their work for them? In other words, will the ECB be forced to taper, or change the self-imposed rules of the APP in light of the above?

The current APP is comprised of the following:












Why? We estimate there are EUR 861.5bn of eligible central government German bonds, EUR 150.9bn of eligible German agency bonds and just over EUR 535.1bn of state debt (Länder). Adding all this up gives EUR 1547.5bn of eligible bonds and thus only EUR 510.7bn of eligible German securities to buy after applying the 33% issuer limit. The ECB currently owns EUR 368bn of German government debt (23.97% of total PSPP net purchases) and if it continues buying the EUR 42.3 bn allocated to the PSPP programme according to the Bundesbank’s capital key (17.99%), it gives them up to a maximum of 18 months before the ECB owns the remaining EUR 142.7bn of eligible German securities it scan still buy. Naturally this is an upper bound estimate of the limit: the ECB cannot own more than 33% per issue, for which 33% of total debt stock is a necessary but not sufficient condition. Unfortunately, the ECB does not provide data on how much of each bond it holds, so this is the furthest we can go.

The PSPP program is constrained by various factors, the two key ones being 1) the 33% max limit per issuer for all non-supranational bonds (applied to the universe of eligible assets in the 1 to 30-year range of residual maturity) and 2) the fact that “priority” will be given to purchases of assets with yields above the DFR (the current ECB deposit rate of -0.4%). These can be changed by the ECB Governing Council at any time, but the relative scarcity of German assets under current rules will become critical going forward given that we expected current constraints could be binding given the ongoing need to accumulate bunds at the rate of just under EUR 8bn per month by late 2018 at the latest.

What does this mean?

As with Fed, we believe ECB will need taper the PSPP program before it can raise interest rates to avoid violating its own rules, especially if bunds stay bid and do not move in tandem with the changes in the ECB refi rate. Furthermore, the ECB has bought itself until the end of 2018 to complete the taper, and, perhaps to embark on the first rate rise since he ill-fated rate increase rise of 2011.


Where are we in the dollar cycle?

  • The US dollar is at an inflection point. Can the dollar’s cycle continue in the face of convergent economic fundamentals and central bank coordination?

US policy rate normalisation does not guarantee dollar strength – real interest rate support crucial

The US dollar is at an inflection point. On one hand the real exchange rate is yet to comfortably pass its long run average, implying further room for appreciation, while on the other the humdrum chorus of gloomy global economics and a false hopes for US rate normalisation could threaten to pour water on the fire. Indeed, Fed watching has become a favourite pastime for many, presumably in the hope of uncovering clues as to the dollar’s next step, however focusing on the Fed alone is unlikely to uncover the dollar’s secrets. Unfortunately, Fed normalisation cycles alone have never truly been enough to predict a sustained appreciation in the US dollar, and there is no discernible relationship between US rate normalisation, and the nominal or real exchange rate (figure 1). This is natural as currency is and always will be a relative concept.

With this in mind, and given small differences in the level of development between the US and most other developed markets, real interest rate differentials can help us to determine the dollar’s true attractiveness and in turn explain a good deal of behaviour in the medium run (in fact, interest rates and price differentials form the basis for most currency valuation models).  Increasing real interest rates (ceteris paribus, of course) help drive the dollar higher but this effect is more prominent in longer-dated real interest rates than shorted dated. The message one could take is that short term real interest rate normalisation is a necessary but not necessarily sufficient condition for dollar strength, and the US dollar’s destiny may be determined more by elusive long-run forces, in other words natural real interest rates.



Figure 1 and figure 2. Source: Macrobond, J.P. Morgan

Is there scope for real rate divergence?

In view of the theory that US dollar appreciation requires an ascension of US real interest rates relative to the rest of the world, the US dollar cycle may have hit a stumbling block. Declining natural real interest rates have been a global phenomenon (the BIS here and BoE  here have written extensively on this topic), with lower growth, a savings glut and rising inequality as cited culprits. For significant divergence in the long-end of the curve, these fundamentals in the US need to improve. This will be a challenge; even the Federal Reserve has been forced into submission by the secular stagnation thesis as the bank’s long-run projections of interest rates have continued to shift towards that of the market. A similar reality is also evident in the short end of the curve; forward guidance, global economic coordination and increased responsiveness to shocks by central banks are creating fewer economic surprises, fewer opportunities for divergence, and are suppressing interest rate and currency volatility (figure 3).


Figure 3. Source: Bloomberg, Macrobond, Citi Economic Surprise Index

Can the world cope with a stronger dollar?

While the bar for a stronger dollar would seem high, we believe the US can cope with a stronger dollar, and economic impacts should not hold the cycle back. The US economy is relatively closed with trade making up only 30% of GDP, therefore a stronger dollar is unlikely to pose a large threat to growth via the trade route. Additionally, we should not be too concerned about the currency’s impact on inflation in the US; currency pass-through to inflation is  the lowest among G10 economies (figure 4), in part due to the limited degree of openness but also because the vast majority of US imports are denominated in dollars, limiting the impact on inflation to volume effects only (as foreign imports are diverted elsewhere). 

We think that the rest of the world can too cope with and may indeed benefit from a stronger dollar. Firstly, most developed economies are not troubled by high inflation and would likely welcome a boost in price levels. In particular, the Bank of Japan and European Central Bank are plagued by currency strength and diminishing returns to ever expanding easing programs. In the Emerging Markets, a stronger dollar is not quite what it used to be; most sovereigns have reduced hard currency borrowing significantly, and while in some countries corporates may still be exposed to fx liability risk, EM central banks boast larger foreign currency reserves than in previous hiking cycles, and governors that are more adequately equipped skill-wise to deal with all the economic shocks that a stronger dollar would bring. 


Figure 4. Source: “The International Price System” , Gita Gopinath (2015). Eurozone is an average of Italy, France and Germany

Have currency markets become more choppy recently?

  • Are currency markets stuck in a period of short-term mean reversion? If so, what’s driving this and what are the implications for investors?

One straightforward way to look at the level of mean-reversion (‘side-wayness’ as opposed to ‘trendiness’) in an asset over a given period is to look at the so-called Vertical Horizontal Filter (VHF). In essence, this measure computes the difference between the highest and lowest level in the asset price and divides this by how many ‘steps’ it took on the path to get there. The VHF measure was developed in the early 1990s and a low measure would indicate a choppy market, whereas a high measure would indicate a trending phase. In terms of our own preferred definition, mathematically it is : VHF = (Max({Spot in 250 days}) – Min({Spot in 250 days})) / (SUM_{t=2}^{250} (Spot(t) – Spot(t-1))). In other words,  the numerator is the absolute value of the highest close minus the lowest close over the course of a year. The denominator is the sum of the absolute value of the difference between each day’s price and the previous day’s price over this same year.

Below we show the VHF measure for the most liquid currency relationship, namely, the EURUSD cross. The chart shows that we have been in a mean reversion period for most of this year, with effectively this pair trapped in the 1.05 to 1.15 range. Why so? We argue that the Fed backtracking over the trimming of their second rate rise this year has had an impact in dampening further prospects for US Dollar appreciation. At the same time, although the Eurozone has engaged in an expanded QE programme, inflation remains low, and so real interest rate differentials between Europe and the US are not large. The market is now, we believe, pricing in new normal or “neutral” real interest rate (1%) that is much lower than in the past (2%-3%) and this is reflected in flat forward curves in interest rates. This applies to both currency blocks. What do we need for this mean reversion to stop and a new equilibrium to be found? We believe that real rate expectations need to be dislodged from their current static equilibrium and, if so, most currency pairs, including EURUSD will find new equilibrium levels as real interest rate differentials act as drivers of spot rates going forward, something that has been driving Emerging Market currencies of late in fact.




What next if negative rates fail

  • In response to almost a decade of QE and with little discernible effect, central bankers have now resorted to negative interest rates. What is the zero lower bound and are below zero rates having the desired effect?
  • If negative interest rates fail to halt deflationary momentum, could more extreme options such as ‘helicopter money’ be a viable next step?

Negative interest rates can now be seen across the developed world, ranging from -0.1% in Japan to -0.75% in Switzerland. As more central banks dive into negative territory and with other such as the BoE not ruling the option out, it raises questions such as how low can negative rates go, and are negative rates effective in stimulating demand? In answer to the first question, theory goes that since cash holds an implicit carry of zero percent, the zero lower negative bound should be equal to the cost of insuring and storing the cash. In reality, the zero lower bound may be unlimited. If banks were to create additional charges for withdrawing cash exactly proportional to the negative interest rate on offer, the monetary benefit of withdrawal would be zero. To make things even more difficult for cash hoarders, in years to come there may be no cash to hoard; on the 15th February the ECB council voted to scrap 500 Euro notes, which represent around 30% of notes in circulation. In a cashless economy there is technically no lower bound.

Policy Rates

It would appear that whether negative rates work is directly related to the ability of savers to withdraw their deposits. In a world where there are no barriers to deposit withdrawal, negative interest rates could reduce the pool of loanable funds in the banking system and push up nominal interest rates. Of course, central bankers understand this, which is why we can expect to see further attempts to move towards a cashless economy. Already, negative interest rates are having unintended consequences. For example, most banks affected are showing reluctance and or the inability to pass on negative rates to depositors, while flatter yield curves from central bank bond purchases erode earnings on longer duration assets, hitting the bottom line through net interest income. When QE and negative interest rates are supposed to spur credit creation and animal spirits, fragile banks profitability and rising risk premiums will not help the cause. The Bank of Japan in its most recent move argued that the channel by which negative interest rates work is through asset reallocation and inflation-friendly exchange rate depreciation. The logic is correct, but currency is ultimately a zero sum game, and with disinflation becoming a global epidemic, a beggar thy neighbor currency policy is destined to fail, unless others (the US) can successfully shoulder massive  currency appreciation.

If negative rates prove problematic, where will the next round of easing come from should we face another global downturn? One potential policy gaining traction in the financial world is ‘Helicopter Money’, a term coined by the economist Milton Friedman. Conventional QE as we know it, indirectly reduces government borrowing costs and is not permanent (newly created reserves eventually disappear as debt matures).  Helicopter money in a modern format would be permanent QE, directly financing government spending or tax cuts indefinitely by purchasing bonds specifically issued by the government, either in the primary market (unlikely) or through the secondary market (legally and politically more defensible). This process could provide the boost the world economy needs, but there are dangers that need to be considered before a central bank and government decide to take the plunge.

For helicopter money to work , firms and households need to believe that any extra income received is permanent and will not remain a liability to the treasury, to be funded by tax at a later date. This can only be achieved if the bonds are wiped from the central bank’s balance sheet altogether, forgoing future payment. This free money would be appear fantastic to politicians and budget setters, but the central bank would find itself insolvent. While insolvency is not technically an issue at a central bank, the new structure of the balance sheet means its interest paid on excess reserves would likely exceed interest received on its assets. In this case more reserves are required to cover any income shortfalls, the balance sheet would grow out of control, and the central bank inevitably loses control of inflation. The alternative is to keep interest rates low enough such that interest expense matches asset income and the bank continues business as usual. This however implies maintaining low interest rates for an extended period, and again would probably result in loss of control over inflation.

Looking at the bigger picture, we cannot escape the truth that we are in an new era of poor demographics and subdued productivity growth, where the need to de-lever private and public balance sheets hinders the ability to generate growth and inflation. The longer central banks wholly bear the burden, the more they will be pushed into a corner with few remaining options. For these reasons, helicopter money or other extreme options such as wide-scale debt write-downs may gain more support across the board, with the understanding that a reset or purge of some sort may be a painful but necessary course of action in the long run. In some sense it has already begun; when the Bank of Japan owns over 30% of government T-bills and bonds, with little hope of reversing course, can we call it helicopter money yet?


Swiss Interest Rates: Lower for Longer ?

  • Has the SNB reached the Zero Lower Bound? After last week’s ECB deposit rate cut, we assess the likelihood of further accommodative monetary policy in Switzerland.
  • By applying a Taylor Rule approach to reveal the SNB’s own estimate of the neutral real interest rate, we estimate that there is indeed room for further interest rate cuts, especially as domestic Swiss real interest rates are still moderately elevated.

After last week’s highly telegraphed announcement, the ECB decided to cut the deposit rate deeper into negative territory (now at -0.30%) despite the fact that Mario Draghi himself had said earlier in the year that, for all intents and purposes, the ECB had reached the zero lower bound (ZLB). Such is what we have to come expect from central bankers over the last few years as forward guidance mutates into data dependent actions and then back to forward guidance. It’s a tricky balancing act as both central banks and markets are caught in a temporary equilibrium where each other’s perceptions feed into actions, and vice-versa. In this latest round of the game of musical chairs, the market was left without a chair last Thursday when the music stopped, and the repricing was abrupt and instantaneous.

With such an opening act, what might we expect from the SNB this Thursday (December 10), and beyond? The chart below illustrates a way to think about this, namely, by trying to ascertain from previous policy actions what the SNB believes the neutral real interest rate (NRIR) might be. Using a traditional Taylor Rule, the chart below shows the range of 3m CHF Libor rates consistent with a -2 to 2% NRIR (as per Wicksell’s conception of this equilibrium interest rate).

By setting a policy rate at -0.75% (towards the middle of the pink band) it would be safe to assume that the SNB probably believes the Swiss economy’s NRIR is currently about 0%. This would be consistent with the latest quarterly GDP data and but also with a long term decline in the rate of labour force growth which will begin to kick in over the next few years as well as slowing productivity growth post the 2007/8 Global Financial Crisis.

Swiss 3m LIBOR

What does this mean for SNB policy going forward? If 0% is the new normal NRIR, then the current real interest rate (taking into account the SNBs’ own latest inflation forecast of -0.5% as per its latest quarterly forecast round in September 2015 (see here) is 0.5%, which means another cumulative 50bps of cuts is not of out the question if the SNB were to move to its NRIR estimate as revealed by this Taylor Rule framework.

While we think the SNB may not cut in the short term, it does appear that there is still room to cut rates further, especially as evidence points out that the ZLB may not yet have been reached in Switzerland. For example, the steady increase in 1000 CHF notes in circulation is line with the historical average and bank deposit data show no major shift into cash from retail deposits. The risk, of course, is that as the ZLB is reached, the SNB loses control of the monetary base once individuals begin to withdraw large amounts of electronic deposits and convert them into cash, for which there is currently no penalty. No one knows when the ZLB will be reached, and the SNB might yet try to test this level once more. Where the ECB goes, it would appear, others must follow.



SNB vs CNB : Currency Interventions

  • The economic rationale for entering, and ultimately exiting a regime of exchange rate interventions is markedly different for the Czech National Bank relative to the Swiss National Bank.
  • The central bank balance sheet, politics and nature of the underlying economy (and currency) are, amongst other things, important factors in helping determine the likelihood of a central bank continuing to intervene in the FX market.

On the 15th of January, the SNB abandoned its 3 and a half year old policy of preventing the Swiss Franc from appreciating to below 1.2 Francs per Euro. The move caught market participants by surprise and created a large degree of panic and uncertainty in currency markets. Just like the SNB, the CNB began a process of preventing the Czech Koruna from appreciating to less than 27 per Euro in late 2013 that continues to date. In this post, we wish to explore the differences between the two regimes and the reasons behind why we think the CNB’s EURCZK floor may be seen as slightly more predictable and manageable (today) than the EURCHF floor given the events of January 15th.

Floor Entry Rationale

The SNB established the exchange rate floor on the basis of an extremely overvalued Swiss Franc. While deflation was a secondary concern, the primary concern appeared to be the economic impact of a highly overvalued currency on Switzerland’s real economy (particularly exports) and the real economy impacts of extreme levels of exchange rate volatility. This was emphasized in the original monetary policy statement and later on by members of the SNB as well.

The CNB on the other hand stressed the importance of meeting its inflation target of 2% +/- 1% after hitting the zero lower bound of interest rates in the year prior to launching interventions. The potential use of the exchange rate as an instrument in monetary policy was discussed in the months prior to the official announcement of the interventions and the decision was framed as being data driven and necessary purely to fulfil the CNB’s inflation targeting mandate.

In sum, the CNB exchange rate regime was introduced to ensure price stability. The SNB’s interventions were announced to ensure exchange rate stability and to give local businesses time to adjust to the external shock. So while the CNB used the exchange rate as a means to an end, for the SNB, the exchange rate was an end in itself.

This becomes clearer when we analyse the path of the central banks to the establishment of their currency floors. In the SNB’s case, rates were at the ZLB (zero lower bound) for only a month after which a decision on the floor was taken. The impulse was an overvalued exchange rate (EURCHF weakened more than 20 % in the previous 12 months) that had remained extremely volatile over the previous few weeks. In the CNB’s case, rates were at a 0 % for more than a year. Only after it was apparent that deflation was likely to manifest for a sustained period of time was the decision to use the exchange rate as a tool taken up by the monetary board. Furthermore, in the months prior to the intervention announcement, the EURCZK exchange rate had remained fairly stable and had actually strengthened by around 6 % in the previous 12 months.

Finally, it was apparent in early January that the ECB was due to begin quantitative easing. The imminent possibility of at least $50b entering the financial system every month with a lot of it possibly getting routed into Switzerland was probably enough to scare the SNB away from continuing with the floor regime. It appeared and continues to appear unlikely that there can be a flight to safety to the Czech Koruna in a similar fashion.

CHF vs. CZK – Currency Characteristics

It is common knowledge that the Swiss Franc is seen as a safe-haven currency as a result of Switzerland’s external surplus, stable price levels and sound fiscal policy. Such characteristics however make it difficult as well as extremely expensive to artificially suppress currency strength during risk-off periods. This is because Francs are effectively being sold at a market discount to participants in extremely large quantities. The Czech Koruna on the other hand is not seen as a safe-haven currency under most circumstances. It lacks the same economic history and reputation as Switzerland and maintained a current account deficit in the decade prior to the establishment of the EURCZK floor. As a result, both the current pressures as well as the potential pressures on the central bank maintaining its floor are significantly lower relative to the SNB. The lower likelihood of there being large and rapid inflows of capital into the Czech Republic (relative to Switzerland), make its currency floor easier to manage and defend.

Central Bank Balance Sheets

Until the financial crisis, both the SNB and the CNB maintained a similar amount of reserves as a % of GDP. Post 2009 however, and especially around the start of the Eurozone crisis, the SNB began accumulating large amounts of FX reserves to prevent the Franc from strengthening. This level reached a fairly alarming 80 % of GDP by 2015. It is worth noting that reserves as a % of GDP are far higher in Hong Kong (~120%) and slightly higher in Singapore (~ 85 %). However in both those cases, maintaining price stability is not a part of the monetary authorities’ mandate; all that is required is the management of the exchange rate peg (Hong Kong) or basket (Singapore). These economies rely on the dynamic nature of their real economy to do the heavy lifting whenever there is an external shock. The same cannot be said for the SNB and CNB; but the fact that the CNB has a way to go before its reserves even begin to approach the levels of the SNB’s would suggest that the CNB can probably maintain its floor for longer.

Figure 1 : Source Czech National Bank, Swiss National Bank, Macrobond

Figure 1 : Source Czech National Bank, Swiss National Bank, Macrobond

Central Bank Structure and Negative Equity

An exit from a period of maintaining an artificially weak currency floor would result in a central bank bearing losses as its foreign currency holdings would be worth fewer units of local currency once the local currency is allowed to float again (and presumably appreciate). Both the CNB and SNB have maintained that it is not necessary for a central bank to maintain positive equity and that it is perfectly acceptable for a central bank to bear losses for sustained periods of time as long as that behaviour is commensurate with its policy mandate. However, the SNB has historically maintained (unlike the CNB) that it is in the long term interest of a central bank to maintain some amount of positive equity in order to demonstrate credibility to the market, the reason for this being that a central bank should not have to issue banknotes and collect seigniorage purely to meet operating expenses as this may be at odds with its policy mandate. A similar point has been recently made by the Bank of England staff in response to “Corbyn’s QE” and helicopter money. Furthermore, since the SNB is an “Aktiengesellschaft” (German for corporation with shareholders), the SNB needs to maintain some amount of stability with regards to its dividend payments to the cantons that in many cases budget anticipated SNB dividend payments in advance. The CNB on the other hand has operated with negative equity since 1996 and notes that this has had a minimal impact on its ability to credibly conduct monetary policy. They note that negative equity that is a result of changes in the valuation of reserves does not represent a “structural” loss component and would normally have the ability to reverse itself in the long term so long as the central bank is seen as credible and able to fulfil its policy mandate. The SNB can be seen as being more sensitive to absorbing losses on its balance sheet (and possibly more conservative) than the CNB. This political backdrop could significantly impact the willingness and ability of the SNB and the CNB to absorb losses.

In sum, we think the macro rationale, currency characteristics, size of the balance sheet and views on negative equity suggest that the position of the Czech National Bank may be different from that of the Swiss National Bank in January 2015. Monitoring medium-term growth and inflation forecasts, as well as the state of FX reserves will probably be the best indicators of the state of the EURCZK floor, in keeping with its slightly more “data dependent” nature. Interestingly, recent growth and inflation numbers from the Czech Republic point to a possible exit from the regime that may be earlier than what the CNB has stated.