Executive Summary
- Since 2014, asset purchases and targeted longer-term refinancing operations (TLTROs) have been the two main planks of quantitative easing (QE) in the Eurozone. The ECB’s asset purchases led to a significant compression of term spreads, easing financing conditions in the effort to lift inflation to the price stability target. TLTROs complemented asset purchases by providing cheap liquidity to the banking sector, and, thus, strengthening the lending channel of monetary policy, especially during the Covid-19 crisis. But TLTROs have taken a secondary role behind the market-moving asset purchase programmes (APP and PEPP).
- Now, the gradual reduction of asset holding under the ECB’s quantitative tightening (QT) strategy will shift the focus to unwinding TLTRO funding, which will remove most of the system-wide excess liquidity. We expect that the repayment and redemptions of TLTROs will contribute about three-quarters of the ECB’s balance sheet reduction until mid-2024 amid a relatively slow run-off of asset purchases.
- The unwinding of TLTRO funding will significantly impact both bank lending and capital markets. On one hand, the drawdown of excess liquidity will boost market liquidity through the release of collateral; this will help tighten asset swap spreads, a measure of collateral scarcity, which facilitates market-making in quote-driven markets, such as government and corporate bonds. On the other hand, we estimate that removing TLTRO as a cheap funding source for banks will amplify the current decline of credit growth (y/y) by about 1.4pp each month on average. For capital markets we expect a non-negligible impact on corporate credit-risk pricing, with both investment grade and high yield segments widening by +10-15bps and +40-50bps, respectively.¹
- If inflation remains higher for longer, the ECB could be forced to tighten monetary policy further, including by reducing its asset holdings above the amortization rate; this could intensify the effects. However, while the ECB is expected to increase the rate of passive asset run-off, a proactive balance-sheet reduction seems unlikely due to its significantly disruptive effect on market dynamics; for instance, the release of collateral by more vulnerable Eurozone governments and corporates could spur spread widening and raise the risk of fragmentation during a time of further monetary tightening.
