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Analysis – European Central Bank ‘QT’ could be next challenge for turbulent markets By Reuters

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© Reuters. FILE PHOTO: Banners are seen outside the European Central Bank building in Frankfurt, Germany on July 21, 2022. REUTERS/Wolfgang Rathai/File Photo

Written by Yoruk Bahceli and Dara Ranasinghe

LONDON (Reuters) – The European Central Bank is considering a downward spiral of volatile global markets to start reducing its huge holdings of bonds — as governments ramp up spending to respond to an energy crisis likely to trigger a recession.

The European Central Bank, which has bought 5 trillion euros ($4.9 trillion) in bonds over the past decade to raise low inflation, now finds itself battling a record high of 10% inflation.

In addition to interest rate hikes including the unprecedented move of 75 basis points last month, policy hawks want to start quantitative tightening (QT): reducing the European Central Bank’s bond holdings.

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European Central Bank President Christine Lagarde acknowledged this week that the discussion has begun and will continue.

The process may still be a long way off, and it will likely come after the European Central Bank rises to about 2% and is very gradual, but bond markets – sluggish due to aggressive interest rate increases globally, the energy crisis and the collapse of British bonds – are nervous.

“There is a lot at stake in the eurozone when it comes to QT,” said Benjamin Schroeder, chief interest rate strategist at ING, adding that the closely watched gap between Italian and German yields was the main focus.

“But other than the spreads, there are also concerns that further market volatility could be fueled, especially when government funding plans in the eurozone are exposed to the risks of a growing upside.”

At 2.35%, the German 10-year bond yield is up 250 basis points this year and the Italian bond yield is up by nearly 360 basis points – the biggest increase in decades.

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Germany last month unveiled a €200 billion package funded through new borrowing to help cushion the blow from the energy shock. Bank of America expects the net supply of European government bonds to rise by nearly €400 billion next year, an all-time high and well over the €120-145 billion projected this year, influenced in part by the purchase of European Central Bank bonds.

“This consideration also makes practical implementation of the ECB much more difficult,” Bank of America said.

softly and smoothly

Analysts expect the ECB to first phase out the reinvestment of bonds maturing under its traditional bond-buying programme. That would cut its balance sheet by €155 billion “manageable” in 2023 and €300 billion in 2024, ING estimates.

Goldman Sachs (NYSE:) estimates that bond markets should be able to absorb €250 billion annually from those holdings. Ten-year bond yields in the top-rated countries will rise by only 6 basis points and 15 basis points in southern Europe.

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Even if those holdings are dumped, analysts widely expect the European Central Bank to continue reinvesting under its Pandemic Emergency Bond Purchase Program (PEPP), which it turned to countries like Italy and Spain over the summer as a first line of defense for divergence. From the spread of the return they pay on the highest rating in Germany is considered “unjustified”.

Eric Owenyan, Head of European Price Strategy at Morgan Stanley (NYSE:), PEPP recoveries are estimated to be around €151 billion next year.

“To some extent, ironically, PEPP flexibility is a way to continue to do QE while doing QT and could eventually lead to a tightening of margins,” he said, referring to the first half of next year.

ING said the final liquidation of PEPP’s holdings could add to balance sheet cuts in 2025 with a total value of €388 billion. Analysts do not expect the European Central Bank to speed up the process with direct bond sales.

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How QT will be implemented is largely unknown in the same way that quantitative easing was a relatively new experiment.

The Federal Reserve has begun shrinking its $9 trillion balance sheet, and staff recently concluded that bond market pressures could complicate QT by amplifying its impact and raising interest rates more than expected.

The Bank of England’s plans to start QT in early October have been postponed until October 31 as it launched an emergency bond purchase program to stem the bond market rout triggered by the UK government’s September 23 announcement of a “mini-budget”.

“The lesson from the Bank of England is that basically, if you don’t have financial stability, there is no point in trying to pursue price stability,” said Pete Heinz Christiansen, chief analyst at Danske Bank.

The ECB’s big headache is the containment of bond spreads.

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In addition to the PEPP reinvestment, it has also launched a new instrument, the Transmission Protection Instrument (TPI), under which it will buy bonds from countries experiencing an “unjustified” widening of spreads over Germany.

AllianceBernstein Portfolio Manager (NYSE:NYSE), Nick Sanders, said he was “skeptical” how the European Central Bank would achieve QT with such protection measures.

“If you have yields in the eurozone backed by the support that they have, it will be very difficult for them to move into a QT environment without a shock to the marginal spreads, especially Italy.”

Annalisa Piazza, an analyst at MFS Investment Management, said the ECB could also find itself taking over QT during a recession, which could lead to an “excess” of policy.

There is no doubt that the European Central Bank, whose assets rival the Fed, adding to the global balance sheet runoff will be another source of uncertainty for the broader markets.

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The rough rule of thumb, said strategists, is that $1 trillion in QT is consistently equal to about 10% of global stocks.

(1 dollar = 1.0306 euros)

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New York Federal Reserve Securities Link Reverse Repo to Bank Regulatory Change by Reuters

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© Reuters. FILE PHOTO: The Federal Reserve building is seen in front of the Federal Reserve Board and is expected to signal plans to raise interest rates in March as it focuses on fighting inflation in Washington, US, January 26, 2022. REUTERS/Joshua Roberts

Written by Michael S Derby

(Reuters) – Continued massive cash flows at a key Fed facility are largely driven by a change in bank liquidity regulations from last year, a New York Federal Reserve report said on Friday.

The Fed offers what’s called a reverse repo, which allows eligible businesses to store cash at the central bank for a risk-free return. The rule that plays into the inflows is a regulation called the supplementary leverage ratio, which determines how much liquidity banks need on hand.

The SLR standard was relaxed during the most severe phase of the coronavirus pandemic in 2020, when concerns about market performance prevailed, and it was restored at the end of March 2021, to return to a more stringent level.

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Banking economists Jara Afonso, Marco Cipriani, and Gabriel La Spada write: “After the end of the SLR exemption period, banks had less flexibility to expand their balance sheets by increasing their holdings of reserves and Treasuries.” This had a knock-on effect on money market funds, the main users of reverse repo, which drove liquidity into the reverse repo facility.

After the regulations changed, the newspaper said, banks were less inclined to take deposits, and instead the money flowed into financial funds, which had to invest that money somewhere. Meanwhile, banks have cut back on short-term debt offerings, restricting where money can be invested. Moreover, the federal interest rate increases pushed cash into money market funds as financial markets experienced a shift in the cost of short-term borrowing, according to the authors.

The Federal Reserve’s esteemed buyback facility is an essential part of the toolkit it uses to manage its federal funds rate target setting, which it uses to influence the economy’s trajectory to achieve its inflation and employment targets. A reverse repo tool provides money market funds and other companies a place to deposit cash into the Federal Reserve overnight and earn a return. It is currently at 3.8% and is an investment with a better return than many private securities that come with greater risks.

The Fed’s reverse repo facility was largely unused in the spring of 2021, and then flows increased steadily. Inflows peaked at $2.426 trillion at the end of September before easing slightly to Friday’s inflow of $2.05 trillion.

Fed officials were optimistic about the huge levels of inflows. Some have argued that as the Fed raises interest rates and reduces the size of its balance sheet to combat high inflation, inflows into the reverse repo facility should decrease over time. But so far it hasn’t really happened.

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Meanwhile, issues related to the correct setup of the SLR are under consideration by the financial authorities, who are treading cautiously on the issue. “History shows the massive costs incurred by society when bank capital is inadequate, and therefore the urgency that the Fed properly adjusts capital regulation,” Michael Barr, the Fed’s official on bank supervision, said in comments Thursday.

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US Federal Reserve proposes plan for banks to manage climate-related financial risks By Reuters

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© Reuters. FILE PHOTO: An eagle graces the facade of the US Federal Reserve Building in Washington, July 31, 2013. REUTERS/Jonathan Ernst

Written by Chris Prentice

WASHINGTON (Reuters) – The U.S. Federal Reserve on Friday joined other major bank regulators in proposing a plan for how big banks can manage climate-related financial risks, drawing immediate opposition from one member and reservations from another.

The proposed principles detail the expectations for banks with more than $100 billion in assets to incorporate climate-related financial risks into their strategic planning. The proposal was approved for public comment in a 6-1 vote of the Fed’s Board of Governors.

The proposal marks the latest effort by US policymakers to prepare for potential financial risks from climate change, bringing the Fed into line with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), which have separately proposed their own plans.

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The potential impacts of climate change — rising sea levels, worsening floods and fires, and government policies moving away from carbon-heavy industries — could destroy trillions of dollars in assets worldwide.

The Fed said these financial implications “constitute an emerging risk to the integrity and integrity of financial institutions and to the financial stability of the United States.”

The Fed’s plan requires banks to consider climate-related financial risks in their audits, manage other risks, and add climate-related scenario analysis to the traditional stress test. The report suggested that banks should also assess and consider whether they should include climate-related risks in their liquidity reserves.

The debate over the extent of financial system risks posed by climate change has been politically charged. Federal Reserve Governor Christopher Waller opposed Friday’s proposal, raising the question of whether it represented a serious risk to the safety of large banks or financial stability in the United States.

“Climate change is real, but I do not agree with the premise that it poses a serious risk to the safety and integrity of major banks and the financial stability of the United States,” Waller said in a statement released alongside the proposal. “The Fed conducts regular stress tests on large banks that deliver very severe macroeconomic shocks and show that banks are resilient.”

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Gov. Michele Bowman endorsed the plan for public input with reservations, noting that the board should consider the “costs and benefits of any new projections.”

The proposal will be open to public comment for 60 days.

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More than 1,000 New York Times union employees plan to quit over payroll, reports Reuters

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© Reuters. FILE PHOTO: The New York Times Building in Manhattan, New York, US, August 3, 2020. REUTERS/Shannon Stapleton/File Photo

(Reuters) – More than 1,000 unionized employees of The New York Times Company have pledged to quit if the news publisher does not agree to a “full and fair contract” by Dec. 8, according to a union tweet on Friday.

The New York Times NewsGuild sought “inflationary” wages as well as preserving and enhancing health insurance and retirement benefits promised during employment, according to a letter signed by 1,036 members.

“We will be out and about for 24 hours, Thursday, December 8th, if we do not have a full and fair contract agreement in place by then,” the letter said.

Union members are also asking for flexibility to work remotely, among other demands.

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A spokesperson for The New York Times said “While we are disappointed that NewsGuild is threatening to strike, we stand ready to ensure The Times continues to serve our readers without interruption,” adding that the company’s current pay offer offered “significant increases.”

Earlier in March, a group of nearly 600 tech employees at The New York Times voted to unionize as the company faced allegations that it illegally interfered with organizing work.

In August, approximately 300 Thomson Reuters (NYSE: Corp) journalists in the US, represented by the same NewsGuild, also staged a 24-hour strike while the union negotiated a new three-year contract with the company.

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