Eunice Bakr
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A very comprehensive analysis of last week events on FX by my favorite economist

  • TLTRO was disappointing, but some mitigating factors may deter policy response.
  • December offering is more important, after AQR and stress test.
  • Fed policy signal is generated by the FOMC statement more than dot-plot and minutes.

The launch of the new 4-year lending facility by the European Central Bank was disappointing. Participation was light.Some 255 banks (of 382 eligible institutions, which represent more than 1300 entities) borrowed a total of 82.6 bln euros. The consensus was for 150 bln euros, and less than 100 bln was thought to a failure.

Our expectation for poor results was based on three considerations.First, we feared a stigma so that strong banks would resist. Second, the Asset Quality Review and stress test (results next month) might deter participation. Third, prudence suggests that waiting for December, even if one wanted to participate. We thought that banks that had large LTRO borrowing outstanding would likely participate. Italian and Spanish banks outstanding LTRO borrowings are roughly 164 bln euros and 163 bln respectively.

That the ECB could not give away 4-year funding at 15 bp will be cynically dismissed as evidence that the scheme was misguided from the start.The problem the cynics will say is from the demand side not supply, or that the price of money is not the significant problem during the de-leveraging wave that is being driven mostly by the regulatory environment.

We are hesitant about reading too much into the dismal participation today.A repeated poor take down in December would be more significant. We suspect ECB officials will also be reluctant to accept failure at this juncture. The disappointing participation does not really mean that a sovereign bond purchase scheme is more likely. There remain numerous formidable technical, legal and political obstacles.

To be sure, there are numerous other forms of QE if officials wanted.The ECB could buy bank bonds, corporate bonds, and even EFSF/ESM/EU bonds. This is not a prediction, but a description offered to demonstrate that a sovereign QE program is not the only, or even most likely, response to the disappointing TLTRO.

A few banks have acknowledged their participation.Some Italian, Spanish and French banks have confirmed their use of the TLTO facility. Italian and Spanish banks appear to have roughly evenly divided about 30 bln euros. In France, both Credit Agricole (OTCPK:CRARF) and Societe Generale (OTC:SCGLF) acknowledged participating but did not disclose the amount. Dutch-based ING (NYSE:ING) and ABN Amro also said that they participated. A number of other banks indicated they might tap the facility in December.


Even with the disappointing TLTRO, the divergence between the trajectory of Fed and ECB policy is clear.In June, 12 of 17 Fed officials saw the first rate hike coming in 2015. Yesterday's dot-plot shows 14 do now. This coupled with more adamant hawks (two dissents) helps account for the higher year-end Fed funds forecasts.

The median Fed view is for Fed funds to be at 1.375% at the end of next year.This is up from 1.13% in June. The Fed now sees the funds rate target being at 2.875% at the end of 2016 compared with 2.50% in June. The 2017 forecast, published for the first time is 3.75%.

The market is not nearly as sanguine.Look at the Fed funds futures. There are admittedly some liquidity issues, but are not far from what other derivative markets are showing. The December 2015 Fed funds futures (25.6k contracts open interest at $5 mln each notional) is implying an 80 bp rate. The December 2016 contract implies a 1.82% year-end target.

Consider the calendar as well. For the sake of this exercise, let's rule out a Q1 15 rate hike. In Q2, there is a meeting in late-April and mid-June. We have been assuming a June hike that would lift the Fed funds target from 0-25 bp to 25-50 bp. There are four meetings in the second half of 2015. The dot-plots would seem to suggest a hike at all of those meetings, or at least three of those meetings, and is divided on the fourth. This seems aggressive given inflation view (tweaked to 1.6%-1.9% from 1.6-2.0% in the June forecasts) and growth (trimmed to 2.0%-2.2% from 2.1%-2.3% in June).

What many observers do not seem to be paying enough attention to the organization of the Federal Reserve, which we think is important to separate the noise from the signal.The Federal Reserve is designed to have a strong Board of Governor. The regional presidents vote on a rotating basis. When the Board of Governors is fully staffed, they have a 7-5 majority over the voting presidents.

Presently, due to the ongoing conflict between the Democrat President and Republican-controlled Senate, there are two vacancies on the Board of Governors.What mitigate this in terms of relative power between the Board and the presidents is that the NY Fed President is a permanent voting member and Dudley is very much in line with Yellen and the Board of Governors.

At FOMC meetings, non-voting members can and do participate in the discussions.This is why the FOMC minutes often show a wider range of opinion that may be detected in the FOMC statement. The same is true of the dot plots. All the regional presidents share their forecasts. In contrast, the FOMC statement is where the Board of Governors, from which there are few dissents, make their views known, and regional presidents are free to disagree.

Our heuristic approach tries to identify the signal from the Fed policy makers.We argue that operationally the signal emanates from the Yellen, Fischer and Dudley, and is clearer in the FOMC statement than the dot-plot or FOMC minutes. This is particularly important now. The FOMC statement was little changed, except for a reference to inflation "running below" the Fed's target rather than moving "somewhat closer" as it had said in July. All the phrases that illustrate a lack of urgency, including "considerable time" and "significant under-utilization" of labor resources were retained.

It was primarily the dot plots that flummoxed the markets.It was decidedly more hawkish. The fact that the Fed offered revised exit principles is not really key. As QE comes to an end, the Fed's exit strategy is evolving. The new information is still relatively light on details. Many expected such a statement in October meeting, but its "earliness" says nothing about the content of policy or timing, except that it is sooner than it was a few months ago. We note that next year's rotation of vote regional presidents moves in a somewhat more dovish direction than the current configuration.

Ironically, with Lithuania joining European Economic and Monetary Union on January 1, the ECB is going to look a bit more like the Federal Reserve.There will be fewer meetings, and for voting purposes, there will be some rotation of the central banks. The ECB's board is smaller and will still be in a minority when the rotation process begins. While the NY Fed has a permanent vote, no country, including Germany, will have a permanent vote on the ECB. There has been some thought that Germany would seek a permanent seat, but this does not appear to have gone anywhere. It is not clear why another country would agree to it.