While there have been various trial balloons in recent days, hinting that the ECB could start purchasing equities, most notably by the Peterson Insitute, it is unlikely that Mario Draghi will commence outright monetization of ETFs at the ECB’s meeting tomorrow. Still, that does not change the fact that the ECB is rapidly running out of bond to government monetize, which has pushed government yields to all time negative lows, and has so distorted the corporate market that non-backstopped corporations have issued negative yielding bonds: an unheard of event. On the other hand, if the ECB relents, and does nothing, it may be perceived as a sign of tightening, spiking bond yields and sending equities tumbling.
Adding to the pressure, the existing version of the ECB’s €1.7 trillion QE asset-purchase program is scheduled to end in just six months, however so far Draghi has failed miserably at spurring euro-area inflation while the full impact of Brexit has yet to be realized. If the ECB extends quantitative easing – as most economists surveyed by Bloomberg predict – policy makers may have to reconsider what they can buy.
UBS best summarizes the dilemma Draghi finds himself in: “Generally, we observe a dilemma on the side of the ECB: The stronger the credibility of the QE programme, the lower the yields and hence the smaller the availability of bonds trading above the minimum of -0.4% (depo rate). Conversely, the lower the credibility of QE, the higher the yields (at least for shorter maturities), and hence the larger the pool of bonds trading above the minimum rate of -0.4%.”
As a result, not much is expected out of Draghi tomorrow, however as UBS further points out, the ECB may as soon as tomorrow have to adjust the technical rules of its QE programme if it wants to continue buying €80bn of assets until March 2017, or longer. UBS thinks increasing the issue limit on bonds not containing a collective action clause (CAC) and expanding the maturity range of purchases could be easily achieved. Scrapping the deposit rate floor and amending the rules on substitute purchases is also a possibility. However, the Swiss bank regards a deviation from the capital key allocation on purchases as unlikely. In the near term, there is also a low chance that the ECB would expand the range of assets to include bank bonds or cut the deposit rate unless – but this seems very unlikely, too – it is part of a more fundamental monetary policy decision.
What about the ECB’s calendar:
Although 8 December is now our base-case scenario, we acknowledge that moving already on 8 September would have advantages as well. It would give markets and economic agents early clarity about the path of monetary policy after March 2017, and thus stabilise expectations and help to reduce downside risks. Perhaps more importantly, it might be easier for the ECB to decide on an extension of QE in September rather than in December, when Eurozone inflation is likely to be higher (approaching 1% y/y, compared with the current/July rate of 0.2% y/y), which might increase the resistance against a QE extension from ECB hawks. In extremis, a delay until 8 December could even mean that – contrary to our base case – the ECB might not extend QE at all, for example, if a sharp rise in oil prices were to markedly alter the inflation outlook in the meantime.
UBS summarizes the ECB’s policy menu as follows:
So, at least according to UBS analysts, it is likely that the ECB will do nothing tomorrow. Others are more impatient, and as Bloomberg points out, the ECB’s self-imposed purchase restrictions are likely to be a focal point ahead of tomorrow’s announcement, even if no final decision is taken. Draghi said at the last gathering in July that officials have shown they can adjust QE when required, and that there should be no doubt they can stick to their pledge to keep spending 80 billion euros a month until March 2017 “and beyond if needed.” Here are the key options:
Option 1: Changing the Issue and Issuer Limits
- Rule: The maximum share of any single public-sector security that euro-area central banks can hold — known as the issue limit — has already been raised to 33 percent from 25 percent for bonds without collective-action clauses. The cutoffs are to prevent the ECB from gaining the power to block any restructuring plans and to avoid it becoming a dominant investor. The 33 percent threshold also applies to the exposure to any one bond issuer.
- Solution: Raising the issue limit on bonds without collective-action clauses should be “fairly uncontentious,” according to a note by HSBC Holdings Plc. Increasing the limits is the “most likely” choice and could come as early as Thursday, according to Bloomberg Intelligence economists. The issuer limit might also be increased.
- Cons: The ECB could distort markets. It could also be viewed as financing government deficits — which is illegal under European Union law.
Option 2: Changing the Deposit-Rate Floor
- Rule: The ECB must only buy debt with a yield higher than the deposit rate, currently minus 0.4 percent. The rule ensures that losses booked by the central bank when it buys negative-yielding debt are offset by the income gained from its deposit account.
- Solution: Lowering or scrapping the minimum-yield requirement would be one of the easiest options to implement, according to Barclays Plc. In particular, it would increase the available pool of German bonds — two-thirds of those assets are now ineligible after concerns of a Brexit-led slowdown prompted investors to seek a haven for their cash.
- Cons: National central banks — especially in Germany — would be knowingly making a loss on some of the bonds they buy. Still, that doesn’t necessarily imply losses at an aggregate level for either individual central banks or the Eurosystem.
Option 3: Changing the Capital Key
- Rule: QE purchases are shared between the national central banks in line with the capital key, which is roughly equivalent to the relative size of each economy. It means that more than a quarter of the debt bought is German, 20 percent is French, and 17 percent is Italian.
- Solution: The ECB could deviate from the capital key and link buying to the amount of outstanding debt. That would put off scarcity concerns in countries such as Germany. Accelerating purchases in the euro-area periphery could expand fiscal space and benefit the real economy, Goldman Sachs Group Inc. said in a note in August. The central bank has already made small moves in this direction, citing the program’s flexibility.
- Cons: The move would favor securities issued by countries with the biggest debt pile — notably Italy, the third-largest debtor among developed economies after the U.S. and Japan — and so raise concerns over monetary financing. Bundesbank President Jens Weidmann said last month that moving away from the capital key risks blurring the line between monetary and fiscal policy.
Option 4: Expand Into New Asset Classes
- Rule: The ECB’s asset-purchase program started with covered bonds and asset-backed securities, before expanding into fully fledged QE with the addition of sovereign debt and agency bonds. It has since expanded into regional debt and corporate bonds, and its list of eligible agency bonds has been expanded.
- Solution: A bigger step would be to identify new asset classes — Karsten Junius at J Safra Sarasin suggests equities. Exchange Traded Funds might be one route.
- Cons: Some asset classes could prove controversial. For example, buying bank bonds could conflict with the ECB’s role as supervisor. While equity investors might be thrilled at the idea of the institution following its Swiss or Japanese counterparts in buying stocks, a series of less substantial changes would probably prove easier to implement.
Verbal Warning
There are other technical changes that could enlarge the universe of eligible securities. The ECB could alter the rules on substitute purchases or buy longer and shorter-dated debt than the 2-year to 30-year maturities currently allowed. It might also come up with something completely new.
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Operating within the parameters of UBS’ dilemma, “Draghi risks disappointing the market if he doesn’t verbally indicate that something is going to come,” according Holger Sandte, chief European analyst at Nordea Markets in Copenhagen. “If we’re going into an easing package in December then he should prepare for that.” On the other hand, tighten, and watch risk assets selloff.
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What do others expect? More than 80 percent of economists surveyed by Bloomberg say the ECB will extend QE, and a similar share predict it will tweak its purchasing rules. Almost half of respondents foresee action on Thursday, with almost all the rest predicting an announcement at the October or December meetings.
Here is a recap what various individual banks think Mario will do:
WHEN WILL ECB EXTEND QE?
- CITIGROUP (Guillaume Menuet): extension of asset purchases for at least 6 months to be announced this week
- JPMORGAN (Greg Fuzesi): QE to be extended beyond March 2017; formal announcement more likely in December than this week; don’t expect central bank to address scarcity either
- BOFAML (Gilles Moec): ECB can’t keep options open until December; at least a commitment to continuing QE after March 2017 would be needed; “At the very least,” ECB to provide clear deadline this week for final decision to continue QE and signal, in no ambiguous terms, that a “reflection has started”
- CREDIT SUISSE (Peter Foley): expect an extension before the end of the year, alongside technical tweaks to address bond scarcity
- UNICREDIT (Marco Valli): another dose of stimulus is just a matter of time; regardless of the exact time, next move likely to be a 6-month extension of QE until at least September 2017
- HSBC (Karen Ward, Fabio Balboni): ECB needs to extend QE horizon by 6 months to September 2017 from March at the very least
- DEUTSCHE BANK (Mark Wall): no longer expect further easing this week; ECB will wait until December to extend QE
- UBS (Reinhard Cluse): will likely only extend QE at December meeting
- BARCLAYS (Fabio Fois): continue to expect ECB to extend QE beyond March 2017 by 6-9 months with a change to some technical elements, but without expanding monthly limits; that’s more likely in October/December than this week
- GOLDMAN SACHS (Dirk Schumacher): ECB to announce extension of QE program to end of 2017 at Sept. meeting
- BNP PARIBAS (Luigi Speranza): ECB will prolong asset purchases to September 2017 this week
- MORGAN STANLEY (Elga Bartsch): ECB to ease only in December instead of September, with risk that it may not ease at all
- CREDIT AGRICOLE (Valentin Marinov): small chance ECB will extend QE duration beyond March 2017
WHAT ELSE WILL THEY DO?
- CITIGROUP: ECB to adjust modalities of PSPP this week, probably focusing first on increasing the issuer and issue limit from 33% to 50% for bonds that don’t contain collective action clauses (CACs); Bank may also lower the main refinancing rate by 10bp to -0.1% to incentivize banks to take-up ECB liquidity at the three remaining 4-year TLTRO II operations
- CREDIT SUISSE: most likely route is for ECB to retain gradual and flexible approach, loosening restrictions progressively on various parameters
- HSBC: ECB may run out of German assets to buy in 1st half of 2017 on current parameters; Could extend QE horizon by another 6 months just by increasing issuance limit to 50% for non-CAC bonds; another change could be to include bonds with maturities beyond 30 years; option of deeper negative rates will probably be parked for now
- DEUTSCHE BANK: any QE extension would need to be accompanied by other measures such as an increase in the issue limit on non-CAC bonds; further deposit rate cut unlikely
- UBS: may adjust technical rules as soon as this week or in October; increasing issue limit on non-CAC bonds and expanding maturity range of purchases could be easily achieved; Scrapping deposit-rate floor and amending rules on substitute purchases also possible; deviation from the capital key allocation, cutting rates or including new assets is unlikely
- BNP PARIBAS: ECB also likely to modify some of program’s parameters to accommodate buying for longer; raising the issue limit for non-CAC bonds would be easiest option
WHAT WILL THE MARKET RESPONSE BE?
- JPMORGAN (Mika Inkinen, Antoine Gaveau): if central scenario proves right, bear steepening of euro-area curves and some widening in intra-EMU spreads likely, with magnitude of moves depending on Draghi’s tone; Any increase in the issue limit may drive mild bull flattening, while a removal of deposit rate floor would see pivot steepening; a significant move away from capital key would spur bear steepening, intra-EMU spread tightening
- BOFAML (Athanasios Vamvakidis, Ralf Preusser): FX impact limited; risks to EUR may be to upside if ECB doesn’t announce QE extension this week as markets could take it as a sign of strong disagreements within GC on how to extend QE; If ECB commits to extending QE but doesn’t address bond scarcity, expect curves to flatten; front end may cheapen as market trims the implied probability of rate cuts and may see profit-taking in periphery
- CITIGROUP (Harvinder Sian): baseline of 6-mo. QE extension is priced in OIS curve; if we are wrong, market will have to price higher probability of QE taper in 2017; Baseline of pushing the non-CAC bond limit higher infers an aggressive flattening rally that should be used to set up steepeners as other options on the capital key/depo floor will have to be considered
- CREDIT SUISSE: any relaxation in capital key allocations would move markets the most, leading to a narrowing in bond spreads and some EUR depreciation
- CREDIT AGRICOLE: EUR unlikely to come under sustained selling pressure without a strong signal the bank’s asset purchases will be expanded as well
- BNP PARIBAS (Steven Saywell): See risks of a rise in long- end core yields in decision aftermath even if ECB delivers; no meaningful impact on EUR
- DEUTSCHE BANK (Abhishek Singhania): market pricing for further cuts should be lower; any signs of ECB concern over impact of more negative rates may drive sell-off in belly; Recommends short EUR vs JPY in 1Y1Y OIS; impact on EUR curve may be limited even if ECB doesn’t extend QE this month, given flatness of the 5/10 and 10/30 curve doesn’t show when market is pricing an extension
- UBS (Themos Fiotakis): Sooner or later, perhaps even in the upcoming meeting, ECB may need to start addressing certain modalities of its program, ultimately leading to a steeper curve; impact on longer-dated bonds harder to predict; easier to see a steeper curve than higher yields
- BARCLAYS (Giuseppe Maraffino): could see further volatility should ECB opt to wait before acting, hence outright duration and peripheral spread positions don’t offer good risk/reward; Stay short 10Y bunds vs Treasuries, receive 15Y fwd point on EUR swap curve vs wings, long PGB 4/30 steepeners, and long 7Y French ASWs
- MORGAN STANLEY (Hans Redeker): ECB can’t weaken EUR; even if it extends its QE program or cuts rates further, it won’t be able to push down long-term bond euro-area yields substantially to weaken currency given yields are already low or negative
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Finally, here are some charts courtesy of UBS summarizing the state of the ECB’s balance sheet and monetary policy:
Source: Bloomberg, UBS
