We expect the ECB’s Governing Council policy meeting today to end with an announcement to expand its asset purchase programme and include government bonds (with some limits to risk sharing within the Eurosystem in the event of a sovereign debt restructuring) and possibly other euro area financial assets. We expect a commitment (at least through mid-2016) to monthly total asset purchases (EUR50bn, according to the latest news reportedly based on a leaked ECB staff proposal) until the ECB’s immediate target (balance sheet expansion of about EUR1trn) has been met. The latter, however, could be adjusted in both directions, up or down, if required by the ECB’s ultimate target to bring back inflation over the medium term to close to but below 2%.
In terms of the market effect, money market rates will remain anchored at zero or become slightly negative, in our view. Further out on the yield curve, we do not expect the EGB QE announcement to lead to any notable rise in long-dated Bund yields and recommend positioning for further yield grab through our long spread views in 15y French and Belgian paper. In the periphery, we keep our core (Italy and Spain) spread tightening view into the ECB meeting and initiated a BTP curve steepener via short 30y BTPs vs 50% long 7y and 50% long 15y BTPs.
We think it very likely that the ECB will announce an expansion of its asset purchase programme today and will soon also buy government bonds of the euro area’s member states. Both conditions for the actions that the ECB put forward have been met, in our view: 1) the current purchase and TLTRO programmes are not enough to reach the balance sheet expansion target (from EUR2.15trn currently to EUR3trn, or to roughly 30% of euro area GDP); and 2) the inflation outlook has materially worsened further.
Total monthly asset purchases of about EUR50bn until the ECB’s immediate target (balance sheet expansion of about EUR1trn) has been met sound reasonable to us. In our view, these monthly purchases could achieve the targeted balance sheet expansion sometime before the end of 2016, when the TLTRO liquidity operations are also scheduled to end. However, the ECB’s balance sheet target could be adjusted in both directions, up or down, and is itself a function of the medium-term inflation outlook. In addition to government bonds (we expect purchases to extend up to the 10y sector of the EGB market initially and linker bonds to be included alongside nominal bonds), the ECB might also announce that other assets, such as corporate bonds, could be purchased to deflect the focus on the politically controversial government bond purchases, but the lion’s share would fall on government bonds in any case. We believe the ECB is unlikely to buy assets that are not eligible as collateral for its monetary policy operations. The composition of EGB purchases across euro area member states is most likely going to follow the ECB’s (paid-in) capital shares, which roughly correspond to the relative size of member states’ GDP share in the area’s total output. For Greece and Cyprus (rated non-investment grade), an active (“on-track”) financial ESM aid programme is likely to be required at least by the ECB for their government bonds to qualify for the new purchase programme. We do not think the ECB will be very specific today about how the monthly purchases will break down across asset classes, to keep some flexibility in view of varying liquidity conditions for each asset class.
The evolution of actual inflation and medium-term inflation expectations are likely to be the two key variables to feature in the ECB’s reaction function for determining the final total size of its asset purchase programme and the timing for tapering monthly purchases. With a negative inflation print in December of -0.2%, an inflation outlook with negative prints through Q3 15, and inflation expectations sliding further (EURHICPx 5y5yf swap at about 1.5%), we think that the second condition set by the ECB has effectively been met as well. We think that the effect on headline inflation of weak oil prices will dominate price pressures related to a weaker euro in the near term. We forecast euro area headline HICP inflation to average -0.2% this year and +1.0% in 2016.
Besides the potential size and timing of asset purchases under an expanded programme, the question how potential credit losses might be shared remains crucial for the programme’s effectiveness.Recent press coverage (eg, Bloomberg, Reuters, FT, Der Spiegel) suggests that potential losses stemming from a sovereign debt default/restructuring might not be fully shared by the Eurosystem. The risk-sharing issue had been brought up by some of the northern members of the Eurosystem uncomfortable with the idea of introducing “synthetic Eurobonds” through the backdoor. Should a sovereign default become a market concern, large holdings of that country’s debt by its own national central bank and the exclusion of loss-sharing through the Eurosystem would reduce the expected recovery rate for other debt holders, which could cause a sharp widening of its government bond yield and possibly contagion to other sovereigns whose fiscal sustainability might be perceived at risk. On the one hand, the ECB may feel uncomfortable with EGB yield spreads tightening close to zero, which would ignore any difference in the economic and public finance fundamentals of member states that determine public debt sustainability. On the other hand, the lack of risk-sharing, all else being equal, could generate a problem similar to that of central bank seniority over private debt holders and could reignite financial fragmentation across the euro area. All in all, some restrictions to full loss-sharing and only partial mutualization of credit risk (of government bond purchases) within the Eurosystem appear likely to us.
We would expect growth and inflation expectations to receive a boost this year if the ECB announcement comes as laid out above. It should help underpin market expectations of low interest rates for an extended period, which would put further downward pressure on the euro if the US Federal Reserve starts hiking rates this summer, which remains our baseline. It should also help to lift medium- and long-term inflation expectations; as a result, we would expect real rates to drop. Lower real rates and a weaker euro should support investment and export performance and eventually push up inflation. However, this would be a one-off effect felt mainly in 2015-16, and it should be clear that a sustainable economic recovery, price stability over the medium term and a smooth exit from the ECB’s extraordinary monetary policy support will be achieved only if all member states fully and in a timely fashion implement the necessary structural reforms and consolidate their budgets in growth-friendly manner.
We expect no change in the ECB policy rates today and the deposit and main refinancing rates to stay at 0.05% and -0.2%, respectively.
Market implications
The massive expected ECB liquidity injection would increase the liquidity surplus in the eurosystem quite notably over the coming months, to levels that would keep money market rates tightly anchored at zero or negative levels. In terms of outright rates in Germany, we would not expect an EGB QE announcement to lead to any notable rise in long-dated Bund yields, unlike past QE announcements in the US and UK. First, the potential reflationary effect of QE is likely much less now, as it has already been used extensively by other DM central banks globally and its surprise element is limited. Second, EGB QE on its own is unlikely to be a panacea for the medium-term euro area economic outlook (both growth and inflation) unless it is complemented by better fiscal coordination across member states and further structural reforms. Third, given falling oil prices, the weak global growth outlook and event risks from geopolitics, long-dated bonds remain resilient due to yield grab demand, even in places such as the US, where the economy is much stronger. Therefore, we expect long-dated German bond yields to remain low and recommend positioning for further yield grab through our long spread views in 15y French and Belgian paper.
Our view remains that the most spread tightening-friendly scenario would be full risk-sharing by the Eurosystem (ie, full mutualisation of risks) in case of losses stemming from government bond purchases, as in theory it would be similar to a “synthetic eurobond”. Under this scenario, we believe 10y Italian and Spanish spreads would likely continue to tighten below 100bp relatively quickly. However, if the ECB decides to limit full risk, EGB market reaction would likely be a bit tricky. We think if other aspects of the programme do not disappoint (size, scope, etc), then limits to full risk-sharing sharing would be unlikely to lead to a big EGB spread widening. In the near term, the market is likely to focus on the portfolio impact of purchases, ie, how much the ECB buys and what this means for upcoming supply. In addition, the bond market is globally in a yield-grab environment anyway, and any decent widening in EGB spreads is likely to be seen as a yield-grab opportunity by many investors for now. However, under a no risk-sharing scenario, we still think the spread tightening pace over time would likely be slower than for full mutualisation, and the vulnerabilities to volatility generating events could be higher as well. Overall, we keep our core periphery (Italy and Spain) spread tightening view into the ECB meeting. In relative value, we also just initiated a BTP curve steepener via short 30y BTPs (BTP 4.75% Sep 44) vs 50% long 7y (BTP 5.5% Nov 22) and 50% long 15y (BTP 4.75% Nov 29).
Barclays
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