ECB View: Too early to draw strong conclusions about weak TLTRO take-up – Banks borrowed just EUR 3.4bn in the first TLTRO-III operation. The amount was much lower than market estimates, which ranged from EUR 20bn to 100bn, according to Bloomberg News. We should not rush to strong conclusions about the programme as this represents the first of seven operations which will stretch for each quarter up until March 2021. Critically, banks already had to indicate whether they would participate in today’s operation in August, which was before this month’s Governing Council meeting when the conditions were made more favourable. More generally, banks might be taking a wait-and-see attitude, given uncertainties about the economic outlook (and hence loan demand), funding conditions in debt markets, the possibility of a further rate cut and the introduction of a tiered deposit facility. So although the initial amounts are not encouraging, there could well be a sharp pickup in take-up in the upcoming operations. The first litmus test may come around the middle of next year when the first tranche of TLTRO-II matures (when banks took up almost EUR 400bn of funds, with an amount of EUR 358bn still outstanding given repayments to the end of this month). The potential gross take up of TLTRO-III loans is around EUR 1.7bn, though the net take up of TLTRO loans is reduced by the outstanding amount of TLTRO-II loans (EUR 657bn). So the total maximum potential increase in the stock of TLTRO loans (and hence potential increase in liquidity) is around a trillion euros. (Nick Kounis & Joost Beaumont)
Oil View: Market does not seem to fully price geopolitical risk – After the attack on key Saudi oil production facilities last Sunday, oil prices jumped higher. However, in the aftermath, Saudi officials assured the market that the production facilities will be up-and-running before the end of the month. As a result, oil prices eased to levels only a few dollars above the Friday close. This is remarkable for three reasons. First, if the Saudi statement is correct, oil production will be back to normal at the end of the month, with global inventories sufficient to meet demand. Still, the rumoured request from Saudi Arabia to Iraq for 20 million barrels of oil to supply refineries triggered fresh support for oil prices. This suggests that the market is still somewhat suspicious and highly sensitive to supply-related news. The second reason is spare capacity. Before the attack, the market was mainly driven by supply-related news, which suggested oversupply (US crude production, US inventories, US/Iran diplomatic talks, economic slowdown). But after the attack, the focus seems to have shifted towards risks of supply/production shortages and the impact on the Saudi’s spare capacity. As long as Saudi production is not fully restored, and demand is partially met by tapping strategic reserves, the oil market is extremely vulnerable to new shocks. In case of a new event – this can be a new attack on global oil supply or for instance a hurricane in the Gulf of Mexico – markets could fear that supply would drop further and inventories will quickly dissipate resulting in possible shortages. This could trigger a dramatic price jump. The third reason is geopolitical tensions. Although these tensions have been lingering already for a long time, recent events increase the risk of an escalation. Iran threatened an ‘all-out war’ in case of any US or Saudi military strike. Such an escalation of the situation seems in nobody’s interest, but cannot be fully ruled out. Therefore a higher risk premium than is priced in at the moment may be justified.
We are not revising our forecasts for now. For the coming quarter, upside risks to our base case scenario have increased. If production is brought back to normal and no new shocks are seen in the meantime, downside risks may return again in Q1 2020 and could even rise if other oil producers make use of the momentum to step up their own crude production. We see Brent oil prices at USD 60 at the end of Q4 and Q1 2020, while we see it rising to USD 70 by the end of next year. (Hans van Cleef)
Fed View: Balance sheet decision expected in October – The NY Fed conducted its third repo operation in as many days today to contain funding market pressures that have seen the fed funds rate breach the upper bound of the target range. As we have discussed in prior notes, the pressures appear linked to quarterly tax payments, but are the latest (if extreme) example of pressures in a market seemingly plagued by a shortage of dollar liquidity. We thought the Fed might signal a permanent Standing Repo Facility to deal with this problem, but following Chair Powell’s comments after yesterday’s FOMC meeting, the Fed appears to prefer re-growing its balance sheet to plug the liquidity gap. As recently as June, the NY Fed’s Primary Dealer Survey suggested an excess reserves level of USD1.2trn would be sufficient to meet liquidity needs, but the fact that problems have arisen even at the current USD1.34trn level of excess reserves, suggests a higher amount will be necessary. The balance sheet would in any case have to grow merely to maintain current excess reserve levels, and so if there is already a shortfall, the implication is that the Fed will have to implement a one-off boost to the balance sheet before growing it at a more stable rate thereafter (something in line with nominal GDP growth). It is hard to know by how much that one-off boost to the balance sheet would be, but with banks asking for USD84bn at today’s repo operation, and excess reserves likely to decline somewhat further in the coming weeks, we estimate USD100-150bn would be necessary. In any case, we expect a decision on this to be taken at the next FOMC meeting on 29-30 October.
Asset purchases to resume, but unlikely to have monetary policy implications – How would the Fed go about growing the balance sheet? While we thought the Fed might prefer a longer term lending facility, on closer inspection of Chair Powell’s remarks, it looks as though a return to net asset purchases will be the preferred method. This could pose a communication challenge for the Fed, with some likening such asset purchases to a QE resumption. However, purchases with the purpose of plugging a liquidity shortfall should not alter the stance of monetary policy if they merely take Treasuries from the market that would have in any case been held for liquidity buffer purposes (as occurred in the pre-financial crisis era). As such, the move is unlikely to alter the case for rate cuts, contrary to our initial post-FOMC thoughts. As a base case, we continue to expect additional economic weakness to drive a further two rate cuts this year, though the risk is for just one more cut given the surprisingly restrained projections of more dovish Committee members. (Bill Diviney)