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ECB: The big question now is what changes are in store for the QE

THE ESSENTIAL

The ECB’s QE is meant to last until March 2017 and “beyond if necessary” if the inflation outlook is not satisfactory. Given the (weak) inflation we expect, the mostly likely scenario is that the ECB will extend QE beyond March 2017.

It would not be easy to do so, and the programme would have to be modified. Several options for extending QE beyond March 2017 are possible (raising the upper issuer limit, stop prorating purchases to the capital key, and shifting the QE towards other assets), but each has its share of drawbacks. Anyway, the ECB’s QE will once again become a market theme this summer

 

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On 10 March, the ECB Governing Council raised its pace of monthly purchases from €60bn to €80bn and extended it to corporate bonds. It said it did so
because of weaker global growth prospects, stubbornly weak inflation, weak long-term inflation expectations and risks of an appreciation in the euro. This programme is meant to last until March 2017 and “beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its aim”. Given the (weak) inflation that we expect, the most likely scenario is that the ECB will extend QE beyond March 2017. But this would not go off without a hitch! Far from it.

The technical limits of the ECB’s QE

The ECB’s public sector purchase programme (PSPP), which makes up most of its QE programme, is subject to a large number of technical restrictions:

  • The residual maturity of bonds must be between two and 31 years
  • Yield to maturity must be higher than the deposit rate, which is currently -0.40%
  • An issue share limit for each security (25 or 33%)
  • An issuer share limit (33% except for “supra” securities, for which the limit is 50%)

Meanwhile, these purchases are prorated to national central banks’ weightings in the ECB’s capital, and only 20% of risks are shared by euro zone states.

QE’s technical restrictions will quickly become an issue. Germany’s large share in the ECB’s capital (about 27%), its shrinking public debt and the fact that the German yield curve is below -0.40% until maturities of 5 years suggests that the PSPP will not be feasible for Germany until about March 2017. This estimate is obviously extremely sensitive to market fluctuations as a large number of German bonds have residual maturities of about 3, 4, 5, 6 years.

Press coverage has also highlighted that the Eurosystem could soon reach the issuer share limit for Ireland and Portugal.

The current solution when the issuer and issue share limits are reached is for the national central bank concerned to instead buy bonds issued by supranational institutions. Raising the issuer and issue share limits from 33% to 50% has expanded the stock of PSPP-eligible “supra” securities to about
€60bn, which is enough for years of PSPP purchases for Ireland or Portugal but only a few months for Germany. Availability of German paper is more than ever the real key to PSPP’s feasibility.

The ECB’s QE adjustments will be essential if QE is extended beyond March 2017.

What adjustments should be made to QE?

Several options are possible for extending ECB’s QE after March 2017:

  • Raise the issuer and issue share limits. The ECB said that its 33% issuer share limit was designed to “to safeguard market functioning and price formation as well as to mitigate the risk of the Eurosystem’s becoming a dominant creditor of euro area governments”. Raising the issuer and issue share limits from 33% to 50% would expand the stock of PSPP-eligible German securities by about €140bn, or about nine months of PSPPs for Germany. This is no doubt the simplest way to extend QE but also the one that would exert the greatest pressure on German yields, which banks and insurance companies would not like.
  • Stop buying sovereign bonds prorated to countries’ weighting within the ECB capital structure. Buying fewer German bonds and more bonds from other euro zone countries would also be a way to gain time. Lowering Germany’s weight in the Eurosystem’s purchases from its current 27% to, say, 15% would “add” about nine months of PSPPs for Germany. This would help relieve pressure on German yields more than the previous measure, but it would be “politically” hard to get the Bundesbank to sign off on it. Moreover, a new way would have to be found to calculate each country’s weightings, which would not be easy at all (prorated to public debt?). No doubt that this solution would be very good news for peripheral bonds.
  • Change the type of purchases. QE could be extended beyond March 2017 through a radical change in its composition: an increase in investment grade corporate bonds? High yield bond purchases? Equity purchases? Purchases of listed real-estate investment funds? For the moment, PSPP accounts for the largest portion of the €80 bn in monthly purchases. It is supplemented by ABSPP and CBSPP 3 (respectively ABS and covered bonds). The percentage of PSPP in this €80bn could be lowered. Several options are possible but, once again, they would be hard to put through “politically”, particularly as some countries would be against the acquisition of risky securities. Assuming that this option is taken up, sovereign bond purchases would automatically shrink.

What would the impact be on the bond market?

When a major central bank conducts a QE policy, the slightest hint of a possible adjustment is likely to have a signifi cant impact on bond yields. The most famous example is the infamous “temper tantrum” of May 2013. Ben Bernanke, then chairman of the FOMC, said that the Fed could reduce its QE3 securities purchases, sending US 10-year yields up from about 1.60% to 3% within four months. Emerging currencies were hit hard during this episode. Sooner or later, Euro bond investors will face a similar episode, but it is highly unlikely to be of the same extent.

The “taper tantrum” caused the markets to price in a slowdown in securities purchases and imminent hikes in the Fed Funds rate. FOMC members then had to talk fast to detach interest rate expectations from QE policy expectations. Not until December 2015 did the Fed fi rst raise its Fed Funds rate and, for the time being, the markets are pricing in just one more rate hike in 2016.

Let’s turn back to the ECB’s QE extension beyond March 2017. Even assuming that the ECB decided to buy fewer sovereign bonds (shifting from sovereign bonds towards corporate bonds or equities) or fewer German bonds each month (if sovereign bond purchases were no longer prorated to countries’ capital in the ECB, but based on another metric), the ECB’s monetary policy would remain extremely accommodative with the modified QE and there would be no reason for a change in interest-rate expectations that would send long German yields up sharply in a taper tantrum-type episode.

When will a decision be made on whether to extend?

It was on 22 January 2015 that the ECB announced plans to start a QE programme. Initially, the programme was to last only until September 2016. On 3 December 2015 it postponed the scheduled end date to March 2017. So the announcement of an extension was made about nine months before the “scheduled end”. Based on the same scheme, the ECB is therefore likely to decide right about now whether to extend the QE beyond 2017… That said, the extension decided in December 2015 comes amidst some urgency to undertake easing measures. The decision to extend QE after March 2017 can reasonably be expected to be made in September 2016, which means that the QE’s ECB will once again be a market theme as early as this summer.

 

Availability of German paper
is more than ever the key
to the PSPP’s feasibility

 

2016-06-01-1

 

2016-06-01-2

 

When a major central bank
conducts a QE policy,
the slightest hint of a possible
adjustment is likely to have
a very heavy impact
on bond yields

 

2016-06-01-3

 

The ECB’s QE will once
again become a market
theme this summer

 

The ECB’s QE is making euro zone states solvent again

Clearly, the ECB’s actions since June 2014 have driven sovereign yields down sharply but also sovereign spreads. It is also commonly believed that these actions have provided a boost to economic growth. So, naturally, they have benefited trajectories in euro zone government debt.

The debt/GDP ratio is driven by three main factors: the nominal interest rate paid on existing debt, nominal GDP growth and primary account (i.e., the difference between government receipts and expenditures not counting debt servicing). Public debt trends are generally summed up in a simple equation:

2016-06-01-formule

 is the debt/GDP ratio in t, r is the nominal interest rate on existing debt, g is nominal GDP growth, pt is the primary surplus, and ddat is the debt-deficit adjustment (financing needs are not always strictly equivalent to public deficits as they include, among other things, the government’s financial investments). One of the keys to debt sustainability is whether the nominal interest rate is higher than nominal GDP growth or whether the real interest rate is higher than real GDP growth. There is a so-called snowball effect when real interest rates are higher than real GDP growth.

We have broken down debt/GDP trends into several components up to Q4 2015: the difference between the interest rate and growth, the primary account, and the debt/deficit adjustment.

The debt-to-GDP ratio declined in several countries in 2015. It increased in Finland, Slovenia, Austria. The most spectacular drop is Ireland (from 107.5% to 93.8%).

The Eurozone debt-to-GDP ratio declined slightly over the recent quarters. Since Q3 2015, the differential between the average interest rate paid on the debt and the nominal GDP growth contributed to a reduction of the debt-to-GDP ratio: this had not been the case since early 2008.

Globally, the fall of interest rates and the improving GDP growth figures (at least in real terms) is clearly helping Eurozone countries at least to stabilize their debt-to-GDP ratio.

  • The debt-to-GDP ratio continued to fall in Germany, mostly thanks to the significant primary surplus.
  • For France, the primary deficit remains an obstacle to the reduction of the ratio. For Italy, the “interest rate – GDP growth” differential is still making the debt-to-GDP increase, although less than in the recent years. The primary surplus helps to counterbalance this factor.
  • In Spain, the debt-to-GDP ratio stabilized but that was thanks to very strong growth figures (can this last for years?) and a strong reduction of the primary deficit.
  • The main factor behind the sharp drop of the debt-to-GDP ratio in Ireland is now the “interest rate – GDP growth” differential (very strong growth).

     

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Cross Asset of June 2016 in English

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DRUT Bastien , Senior Strategist at CPR AM
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ECB: The big question now is what changes are in store for the QE
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