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Easy as 1-2-3 (trillion)

11 December 2014 By Neil Unmack

Sovereign QE in the euro zone is becoming a mathematic inevitability. The poor turnout at the European Central Bank’s latest four-year loans means President Mario Draghi is more likely to have to buy sovereign debt to reach his 3 trillion euro balance sheet target. Small wonder markets aren’t too disappointed.

The 130 billion euros banks drew brings the total so far from the ECB’s four-year, ultra-cheap funding tools, to just 210 billion euros, half the amount the ECB had pencilled in for these “targeted longer-term refinancing operations.” Analysts are scaling back their expectations of how much banks will draw at the next four windows. RBS reckons in all 300 billion euros. The ECB’s battle against lowflation is unfolding in slow motion.

What’s not to like about four-year money at 0.15 percent? One problem is that many banks wouldn’t know what to do with the money, and don’t want to take it if that means stashing it at below-zero returns, due to the ECB’s negative rate policy. Credit demand is weak in some countries, and carry trades with sovereign bonds aren’t as profitable as they used to be.

The ECB wants to increase its balance sheet to around 3 trillion euros, against a little more than 2 trillion now. That was supposed to be achieved through the TLTROs, as well as purchases of covered bonds and asset-backed securities. But the amount banks have drawn will not even offset the maturing three-year loans from 2012. Bond purchases will have to reach almost 1 trillion euros. They will need to include sovereign debt, the only market large enough to support a programme this size.

Yet, euro-style “quantitative easing” will be tricky. There are some technical issues – for example, will the ECB take losses in a restructuring, as it refused to do in the case of Greece? More important, sovereign purchases are creating tensions on the bank’s governing council, and are unpopular in Germany – a risk when anti-euro sentiment is rising.

Expectation of additional action has helped drive the euro down about 9 percent versus the dollar since June, and the German 10-year yield nearly a percentage point lower. Markets have priced in the benefits of sovereign purchases – but so far are ignoring the challenges, and the costs.

 

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