ECB balance sheet to start shrinking next month?
Interesting research by Nordea Markets: If history rhymes, we could see the ECB’s balance sheet shrink as early as next month.
Nordea reminds us that the ECB is not in full control of its balance sheet, because a sizeable part consists of loans to banks, and demand from the banks determines the allotment.
As part of the accommodative monetary policy, the ECB launched TLTRO’s, Targeted Long-Term Refinancing Operations, the latest in March of 2016. These loans have a four year maturity, but came with an early repayment option quarterly, starting two years after the loan was raised. Thus, the first early repayment date of nearly 400 bln Euro of TLTRO’s is next month, in June.
Nordea posits there will not be a large interest in repaying the ECB:
The loans eligible for repayment will still have two years left before maturity, leaving them attractive from a regulatory perspective (they remain eligible for the so-called Net Stable Funding Ratio). Further, financing at -0.40% for a further two years should continue to look lucrative for a majority of banks. Lastly, there should be no significant stigma involved in using ECB financing any more.
Tightening only a few weeks away?
Nordea also gives several arguments why banks could start repaying as soon as next month, or September for that matter:
Not all banks have been able to meet the lending benchmark, which means their interest rate on the loans will be the rate on the main refinancing operations (0.00%). With the liquidity environment very ample, banks may not have use for all the ECB loans any more. In addition, some banks may consider paying back the ECB early a show of strength, as was seen in 2013, and preparation for an era when central bank liquidity provision will no longer be as generous.
In 2013, at the earliest repayment possibility, banks decided to repay 137 bln Euro of 3y ECB loans. This was nearly 30% of the original loan amount, and much higher than expected.
Nordea hypothesizes that if banks were to repay 30% of TLTRO’s that are eligible for repayment next month, 110 bln Euro of loans would be repaid. A repayment of 110 bln Euro in June implies that the ECB’s balance sheet will have peaked next month, a huge surprise. Of course the ECB will keep adding 30 bln Euro until the end of September at least, but that month also gives another possibility for repayment. It is quite possible that the ECB remaining purchases will not surpass the amount of TLTRO’s repaid early.
The ECB’s balance sheet could start to contract well before the first rate hike and even before the end of the net bond purchases. This would stand in stark contrast to the Fed, which started to let its balance sheet contract only after more than 1.5 years after the first rate hike.
In conclusion, Nordea argues that there is enough liquidity in the Euro Area, and a small contraction of the ECB balance sheet should have no considerable impact on short term rates or bank lending conditions.
They think that a bigger threat is how the market perceives the unexpected, early tightening. The Fed’s balance sheet is already contracting, and if the ECB’s balance sheet will also shrink, financial markets could start worrying about the end of cheap money. This could cause volatility to increase, and risk appetite to diminish substantially.