11 March 2020
Christine Lagarde faces a difficult day at the office tomorrow. The newly installed head of the European Central Bank must attempt to support a euro area which is reeling from the current and expected impact of the Covid-19 outbreak. Last week the Federal Reserve set the tone with an emergency rate cut of 50 basis points, which many investors judged to be not enough, and markets dropped alarmingly. Next among the major central banks came the Bank of England, which produced a 50-basis-point cut of its own on Wednesday and it went a step further by announcing a new funding scheme aimed at increasing bank lending to small- and medium-sized enterprises (SMEs) most exposed to fallout from the virus.
Now the ECB takes the stage. With the refinancing and deposit rates currently sitting at 0 per cent and negative 0.5 per cent respectively, the ECB has little room to cut rates, making its job much more difficult. Ms Lagarde will need to be both proactive and creative to avoid another crisis in the eurozone, something that could happen should the ECB’s policy response appear insufficient.
Of primary concern will be helping those SMEs that face extreme liquidity pressure in the coming months - businesses with fixed costs that are dependent on cash sales will run out of money before long when virus containment measures bring those sales abruptly to a halt.
Talk of lowering taxes and mortgage holidays will help the broader eurozone economy but will not improve the situation facing more leveraged SMEs desperately in need of cash. The ECB needs to step in to help these companies and avert a widespread liquidity crisis by providing funding to banks with strong incentives to pass on that money to firms affected by the outbreak.
Unconventional measures not enough
We expect quantitative easing (QE) to increase from its current level of €20bn. However, a small increase (to c. €30bn) would not be enough to calm European credit markets. For this we believe a larger amount of QE (c. €60bn) is needed, although an increase of this magnitude would be a surprise given the likely opposition from Germany and the Netherlands. The ECB could also raise the 33 per cent limit placed on its buying from any single issuer for its Asset Purchase Programme (APP).
A ‘bazooka option’ could be for the ECB to expand the APP beyond sovereign and investment grade bonds to include high yield debt, exchange traded funds, and possibly equities, thereby providing support for asset prices in other areas of the financial market, although this would be a shock if it came as soon as tomorrow’s meeting.
Ms Lagarde has made clear her desire to employ a ‘collaborative’ style to running the ECB. This approach might be tested to its limits by the Bundesbank and the Dutch Central Bank, which are likely to attempt to block aggressive stimulus. Rate cuts and a small expansion of the APP will not be enough to stop the liquidity crisis at more leveraged and cash starved firms. For that, the ECB will need to think outside the box, and think big.
Energy and transport firms will continue to face significant challenges no matter what actions the ECB takes. And if the Bank cannot summon the shock and awe needed from unconventional measures, expect more volatility and dispersion in European credit. Cyclicals and the broader travel and leisure sectors would face the most pressure if this happens.
Only four months into the job, Christine Lagarde faces a remarkable test. We will know soon enough whether she has passed.
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