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ECB's decisions: what implications for the fixed income markets?

 

THE ESSENTIAL

The ECB took bold measures of monetary policy easing on March 10. In this text, we aim at describing the consequences these measures will have on the bond markets.

The ECB apparently gave up on the race to cut its key rates and on the euro depreciation policy to focus instead on the transmission of monetary policy, especially on the credit to the private sector. We have estimated the amount of corporate bond purchases by the Eurosystem at between €3 bn and €4 bn per month and we think that this will be very hard for the Eurosystem to buy corporate bonds in exactly the same proportion as the credit indices. Making this assumption, our asset purchases’ projections indicate that the pressure will remain strong on European yields and sovereign spreads as long as the ECB gives no indication on when the PSPP. Besides, it is clear that the feasibility of the PSPP for the German sovereign segment will resurface at some point. Euro corporate market investors will be the real beneficiaries of recent central bank measures but one has to keep in mind that excessively low yields on the euro bond market could pose a real problem for investors in the medium term, and cause high volatility in case of stress, particularly on issuers not protected by the ECB programme.

 

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PUBLICATION

 

The situation was growing increasingly complicated for the ECB, with inflation (total and core) near a record low, inflation expectations at rock bottom, the effective exchange rate on the euro threatening to climb, and a lacklustre global growth outlook. It also steeply cut its growth and inflation forecasts for 2016, from 1.7% to 1.4% and from 1% to 0.1%, respectively. The inflation forecast for 2018 is just 1.6%. Interestingly, these new targets are much more pessimistic than those issued by professional forecasters and other international institutions. It was therefore necessary to take action and overcome the disappointment stemming from the Governing Council meeting in December 2015 (extension of the PSPP, deposit rate cut to -0.30%). The ECB went much further on March 10th:

  • Interest rate cut: the refi rate and marginal lending rate were both lowered by 5 basis points to 0.00% and 0.25%, respectively. More importantly, another 10 bp was shaved off the deposit rate to -0.40%.
  • Monthly bond buying was boosted from €60 billion to €80 billion.
  • Investment Grade bonds issued by non-bank corporations were included in the list of assets eligible for regular purchases in the CSPP (Corporate Sector Purchase Programme).
  • A new series of very long-term bank loans (TLTRO-2), each with a term of 4 years and a rate ranging from -0.40% to 0%. As a result, banks will be able to borrow up to 30% of the amount of their outstanding loans to non-bank businesses and households (excluding housing loans) as at January 2016. These latest actions underscore the ECB's undeniable determination to step up to the plate and hit hard. But just what conclusions should we draw from this, and above all what implications will these decisions have for the fixed income markets?

Interest rate cut: the last act? The ECB has lowered its key rates once again. The markets were keenly focused on the deposit rate, which dropped to -0.40%, but had been expected to be taken even lower. At the press conference, Mario Draghi clearly stressed that the ECB had no intention of reducing the deposit rate further (although this option has not been permanently ruled out, as pointed out a few days later by ECB Chief Economist Peter Praet). The ECB appears to have changed course on March 10, apparently giving up on the race to cut its key rates and on the euro depreciation policy to focus instead on transmitting monetary policy, especially loan distribution. This is a sign of appeasement for banks, which had been worried about their profitability.

The ECB surprised the markets by announcing it would expand its QE to include private corporate bonds starting at the end of Q2 2016. The ECB will focus only on highly-rated bonds issued by non-financial companies domiciled in the eurozone, which represents a market of €644 bn. In implicitly committing to financing these businesses, the central bank has sought to limit the tensions seen in recent weeks on the euro credit market. Quite ironically, this growth in volatility is partially the result of the too-low yield achieved by the Euro IG, a direct consequence of QE and of the Bund being close to 0.2%. Indeed, investors have been reluctant to position themselves on the long segment of the curve or on high yield, because the return was insufficient. At this stage, we have very little information on the practical procedures of the CSPP (Corporate Sector Purchase Programme):

  • We estimate that the Eurosystem's monthly purchases are hovering around €3-4 bn per month. The poor liquidity on the secondary corporate bond market is likely to cause the Eurosystem to take more of a position on the primary market. Companies included in the ECB's programme are expected to issue €120 bn this year, i.e. €10 bn per month. If purchases are limited to 33% per issue, the Eurosystem would buy between €3 and €4 bn per month. Alternative approach: we have also observed that monthly purchases made by the Eurosystem, meaning either the Public Sector Purchase Programme (PSPP) or the third Covered Bond Purchase Programme (CBPP3), make up 0.6% of the total size of the two respective markets. By using this same ratio for non-financial corporate bonds domiciled in the eurozone, the amounts of monthly purchases made under the CSPP would come to some €4 bn.
  • Bond buying should be predominantly carried out by national central banks. Within the framework of the CBPP3, over 90% of purchases are made by national central banks. The amounts purchased by the national central banks under the CSPP will depend on each central bank's portion of ECB capital. However, the breakdown of issuers by nationality in the credit index differs significantly from their weight in the ECB's capital. Meanwhile, Peter Praet, Chief Economist of the ECB, announced in an interview published on March 18 that bonds could end up being bought in proportion to the credit index in order to prevent price distortions. The ECB may decide to share the risks in case of default in an effort to steer the national central banks away from exclusively buying domestic paper.

What will the PSPP programme look like once the CSPP starts? Based on the assumption that the Eurosystem will buy €4 billion in corporate bonds each month, monthly sovereign purchases should pick up by €16 billion to between €50 billion and €66 billion per month. Once the CSPP kicks off, monthly Eurosystem purchases may look something like this:

 

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Under these conditions, monthly purchases of German sovereigns should end up at around €16 bn, i.e. approximately €190 bn per year, while net issues by the German central administration in 2016 are pegged at zero, or virtually zero. According to our estimates, the constraints weighing on the PSPP (maturity ranging from 2 to 31 years, yield to maturity higher than the deposit rate, 33% limit on each issue and each issuer) will make the PSPP impossible for Germany by around mid-2017. And while these estimates are highly approximate given their sensitivity to changes in the yield curve, it is clear that the feasibility of the PSPP for the German sovereign segment will become problematic, and that pressure will remain strong on European yields and sovereign spreads alike as long as the ECB gives no indication on when the PSPP will come to an end (not unlike Ben Bernanke's statements on the tapering of the Fed’s QE programme in May 2013). Extending the ECB's QE plan past its theoretical end date (March 2017) would definitely raise questions as to the nature of the bonds being purchased.

We are sceptical about the impact this measure will have on economic growth. IG issuers enjoy exceptional financing conditions as it is, with interest rates already at record lows. On the downside, this measure will very likely exacerbate the difference in terms of access to funding between companies targeted by the CSPP and those that are not.

Euro corporate market investors will be the real beneficiaries of recent central bank measures. Inclusion in the purchase programme has made the difference in performances (and volatility) so far… As the published charts show, since Draghi pre-announced the expansion of the ECB balance sheet in June 2014 (blue bar), and especially since QE was actually announced in January 2015 (red bar) the main beneficiaries of ECB action (until the very last March ECB meeting) were the asset classes included in the purchase programme. The charts refer to the eurozone 1-5 year fixed income curve segment and underline to what extent core government bonds, quasi government bonds and covered bonds together with periphery sovereign bonds, the exclusive targets of ECB purchases so far, strongly outperformed both IG corporate bonds, like the A and BBB rated ones, and HY corporate bonds.

The average yield to maturity of core govies, quasi government bonds and covered bonds has, in fact, fallen by around 60/70 bp since June 2014. At the same time, among asset classes included in QE, periphery sovereign bonds were the real outperformers: Italian BTPs in the 1-5 year segment, in fact, now offer a close to zero average YTM, having almost completely erased the 100 bp ytm level they were trading at by June 2014.

Over the same period and after an initial phase of strong correlation, A and BBB-rated corporate bonds felt the negative effects produced from external risk factors much more than the above cited segments. Being not directly covered by the “ECB umbrella”, higher volatility and vulnerability to risk aversion mounted on lower oil prices and fears of an emerging markets slowdown. In some cases, it is also true that the return of idiosyncratic risk added to these external factors. BB and B-rated speculative grade bonds, in particular, felt the pain more, despite their much lower exposure to the energy sector with respect to their US counterparties. As a result, as we are writing, EUR BB corporate bonds offer a yield still above June 2014 levels, by almost a full percentage point.

…And since the March 2016 ECB meeting, corporate bonds are likely to become the new outperformers in the 1-5 year segment

Since the very last ECB meeting (green bar), corporate bonds have clearly outperformed and are likely to experience further yield compression. As the chart shows, BBB-rated bonds tended to outperform the most among IG corporates, while HY bonds, despite not being included in the purchase programme, rapidly felt the gravitational force generated by the ECB. A look at what happened in the financial sector confirms that spread products very much look to be the real winners from the last announcements at least in the short term, as TLTRO measures reduced systemic risk in the financial system, will contain the supply of bank bonds and support banks through cheaper and stable funding over a long period of time. Cutting the deposit facility rate by just 10 bp, the ECB clearly reduced the risks to banks’ profitability in the markets’ perception, but TLTRO measures look more supportive to bond holders, as they only partially improve the outlook for banks’ earnings.

Monetary policy has its merits but isn't enough! Mario Draghi has rightly stated that without the ECB’s QE, the euro area would have fallen into deflation. True also is the fact that unconventional monetary policy measures are responsible for the financial defragmentation observed over the last 18 months. But monetary policy cannot do everything. It is becoming increasingly clear that without fiscal leverage, the ECB's battle is a lost cause.

A closer look at yield distribution in the eurozone

In just two months, the BoJ’s move to NIRP and especially the new ECB measures have led to quite a reshaping of the yield distribution in EUR fixed income markets.

Since the end of January, in fact: 1) the proportion of debt with a negative yield has jumped to almost 30% of the overall EUR fixed income market, up significantly from 22%; 2) the proportion of debt with a yield at or close to zero has also risen, from 25% to 30%, mainly due to periphery sovereign and IG corporate bonds, 3) on the right side of the distribution, the proportion of debt yielding more than 2% fell below the 10% level (to precisely 9%) for the first time ever. The ECB’s last measures are likely to lead to a further move to the left, in particular, of the orange and purple bars.

 

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It is clear that the feasibility of the PSPP for the German sovereign segment will become problematic, and that pressure will remain strong on European yields and sovereign spreads alike as long as the ECB gives no indication on when the PSPP will come to an end

 

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Euro corporate market investors will be the real beneficiaries of recent central bank measures

 

 

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Monetary policy has its merits but isn't enough!

 

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Article en Français

Cross Asset of April 2016 in English

Cross Asset de Avril 2016 en Français

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AINOUZ Valentine , Credit Strategy
BERTONCINI Sergio , Credit Strategy
DRUT Bastien , Fixed Income and FX Strategy
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ECB's decisions: what implications for the fixed income markets?
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