Draghi to detail QE operation

Last meeting, Draghi gave a broad-based outline of the QE programme

Some importantdetails are expected at Thursday’s meeting

New staff forecasts likely to suggest improving trend ininflation andgrowth

Will the ECB find ready sellers of sovereign bonds?

At its January meeting, the ECB took far‐reaching measures to support activity and combat deflationary tendencies. It announced the start in March of a broad‐based asset purchase programme, that was larger in scope than markets expected (€60B a month). It includes monthly buying of close to€50B? sovereign bonds. It shall do so at least until September 2016 and until there is a sustained adjustment in the path of inflation. In our flash report following the January decision, we talked through the specifics of the programme in so far as they were made public. Markets reacted positively and in the manner that might have been expected (and wanted by the ECB). Core bond yields fell lower and the sensitivity of European bonds to moves of US Treasuries fell sharply. Peripheral yield spreads narrowed.
Also other yield products profited, as did equities. The euro weakened further against the dollar, but stabilized more or less in trade weighted terms.

Is timing QE appropriate?

The ECB starts its programme 6 years after the Fed and the BOE invented and used the asset purchase tool to shore up their economy. In the interim, the situation on financial markets has changed notably. German yields are now below 0% till the 7‐year tenor and similar negative yields are witnessed in many other core or semi‐core markets. When similar programmes started In the US and the UK, the relevant longer term yields were significantly higher. So, it is legitimate to ask whether the ECB programme, when it begins, can it still push European yields even further than they are at present, making financial conditions much easier. Since the ECB announcement, peripheral bond yields dived lower and yield spreads versus Germany have shrunk to the point risk premia may be too low. In the same vein, European equities are at highs, sometimes even historic highs (Dax). Pushing yields lower and riskier assets higher worked well in the US and UK, but in a European context assets might be driven into bubble territory, given their current ‘exuberant’ starting point.

Economic environment changing?

Whereas in January negative factors still dominated the outlook, more recently we have seen green shoots popping up everywhere. Economic data have improved and overall surprised market expectations. The fourth quarter of 2014 growth of 0.3% Q/Q was a positive with strong contributions from Germany, Spain and Portugal. Details are still missing, but we got signals that domestic demand did well. The services PMI has recovered quite strongly, EMU retail sales have risen for three months and strong German retail sales and French consumer spending in January suggest a fourth month running of good sales. the more internationally oriented manufacturing PMI lags, as Chinese growth decelerates. However, it would be a welcome development if domestic spending made a positive contribution to economic growth in the Euro area.

Finally, February inflation surprised on the upside for the first time in a while (‐0.3% Y/Y), core inflation stabilized at an, admittedly too low 0.6% Y/Y. The silver lining though was the rise in service prices within the core prices. Inflation expectations also show signs of bottoming out, even if it would be temerity to call it already a turnaround.

In parallel with the economic data, the money and credit data improved in the past months. Money supply is accelerating, but, more importantly, lending to consumers and now also firms is at last reviving. The weakening of the euro in the past year and the crashing oil prices since mid‐ 2014 has certainly played an important underlying role in the improvement, as does the more neutral fiscal stance and the anticipation of the ECB QE and its effects on asset prices. While we still have concerns sin relation to both the need for and likely effectiveness of QE in the European context generally and more specifically its current timing, we don’t deny that it may somewhat help the economic recovery, albeit potentially by taking on high financial risks.

It will be interesting to see how the ECB staff forecasters will treat these recent developments. For 2015, the staff forecast was for a 0.7% increase of inflation. That looks still too high‐ the EU commission’s latest forecast is ‐0.1% but with a weaker exchange rate and oil prices recovering slightly as well as some limited early impact from QE, the ECB may opt for a marginally positive number. More interesting will be their judgment on 2016 and 2017 inflation (and growth). We could imagine a first upward revision from 1.3% in 2016 reflecting the impact of the factors mentioned above. While the 2017 figure is a first forecast, it assumes considerable significance because it should provide us with the ECB’s sense of the ‘sustained adjustment in inflation which is consistent with our aim of achieving inflation rates below, but close to 2% over the medium term ’that the bond buying programme is intended to deliver. The ECB will be cautious in interpreting these recent positive developments, but if they would strengthen, at some point markets may contemplate a premature end to the QE programme. At very least, the ECB hawks will rear their heads and plead for an end to the programme. However, we don’t expect Draghi will suggest a premature end is likely. This could threaten his hard won credibility with the markets. Any such suggestion would shock the markets and reverse some of the positive financial developments born in the run‐up to the QE announcement.
So, Draghi might look to downplay the significance of the February inflation figures and the stabilization of inflation expectations.

Who will sell its sovereign bonds?

Many important details in relation to the QE programme have not yet been communicated and we expect Draghi to provide some clarifications during the Q&A. We have indications that they won’t organise reverse auctions to buy sovereign bonds, but simply go to the market makers trading platforms or institutional investors. There are also important doubts as to whether enough investors will be ready to sell their bonds. That shouldn’t be a problem in the early phase of the programme, but it could become more important later on. Various factors suggest supply problems may arise. While in the US, the net supply of Treasuries was very high during the programme (fiscal deficit of +10% of GDP), EMU austerity has lowered the deficit for 2015 to a bit above 2%. Germany might even have a net surplus. So, the ECB will have to buy much more than the new accrual of sovereign debt, a sharp contrast with US QE. On the contrary, EMU QE resembles US QE in terms of % of gross supply.

EMU QE is not problematic in terms of its size versus GDP or gross supply, but there are doubts about the willingness of investors to sell sufficient amounts of their bond holdings, given some institutional features and given the current stance of markets.

Various categories of bond holders?(banks, insurers, funds) may also have second thoughts as to whether they will aggressively sell to the ECB. Banks need a lot of sovereign bonds for regulatory reasons. Sovereign bonds are considered highly liquid assets for LCR and are low risk weighted (capital purposes). Of course, as a group they have more sovereign bonds than needed for such reasons.
When they sell bonds they will book capital gains, but what can they do with the cash? If they can lend to the real economy, they might have a strong reason to sell. However, currently demand for lending is still very low, even if some improvement is visible. Banks in this situation may sell part of their portfolio to finance the lending, but they also have the choice to tap the TLTRO facility at a cheap 5 bps. If lending demand increases it becomes more likely that banks will be more willing to offer more sovereign bonds to the ECB.

If banks do not feel they have sufficient lending opportunities, money from bond sales might end up at the ECB deposit facility, which costs them 20 basis points.
These banks may prefer keeping their sovereign bonds.

However, a third possibility is that banks may sell bonds to the ECB and acquire other bonds. Banks may choose to lengthen the maturity, go for a lower rated credit (peripheral bonds versus core) (other credit assets may be less appropriate due to capital requirements) or even look outside the euro area for investment. In the first two possibilities of lengthening maturity or buying higher yielding peripherals, there is only substitution between sovereign bonds, something that would not help the ECB much in reaching the programme goal of boost in Euro area inflation. The purchase of non‐Euro area bonds might cause an unwarranted currency mismatch on the balance sheet between euro liabilities and FX assets and the price to hedge this mismatch.

In conclusion, the most likely action banks might take is selling shorter‐dated bonds (more than, 2‐year) and buying longer‐dated debt. This would enhance yield and not impinge on liquidity/capital reasons to hold bonds.

Can ECB tap into other investor groups?

Non‐euro based banks and investors may be more eager to sell their bond holdings to the ECB, especially as the ECB is obliged to pay a high price. Indeed, for these investors selling gives good value while FX mismatch and reinvestment concerns are less of an issue. This group could dispose of a large portfolio of euro dominated sovereign bonds. For pension funds, insurance and asset managers, the other big holders of euro sovereign debt, pension funds and insurers have regulatory requirements too (Solvency 2) that promotes safe sovereign debt, while asset managers might be constrained by the nature of their fund rules.

Concluding, the ECB may not have too much difficulties to buy about €45‐50B/month sovereign debt in the initial stages with biggest support coming from non‐euro based investors. If the economic recovery nurtures and euro banks have more opportunities to lend, they may have more appetite to sell part of their portfolio to the ECB. Given these potential difficulties in reaching their target, the ECB may need to become a more aggressive buyer, which could help insulate Euro area sovereign bond yields from a rising trend in US Treasuries yields.

Excess liquidity to increase.

Once the ECB starts buying sovereign bonds, excess liquidity, now €163B, is expected to mount gradually to much higher levels. This should drag eonia further down and closer to the deposit rate. Additionally, longer dated Euribors may also drop into negative territory.

Decision on fate Greek collateral

When Greece openly repudiated the bailout package early February, the ECB draw back the waiver that allowed Greek banks to use sub investment grade Greek sovereign bonds as collateral in ECB liquidity operations. It triggered the implementation of the Emergency Lending Assistance (ELA) of the Greek central bank. In the meantime, there is an agreement to extend the bailout package by 4 months. So, with Greece having urgent liquidity needs, the ECB may decide to install again the waiver and so help keep the Greek financial system afloat.