ECB: Action needed urgently

With the current credit widening and particularly Italian surge in yields, we believe we need a forceful response from the ECB to act as a circuit breaker. Last year, we discussed the ECB toolbox in the event of a severe downturn. In our view, what we need now is not a general easing of monetary policy (which is why our baseline is still not a rate cut) but a package/measure that addresses the credit risk and high volatility in bond markets.

We expect the ECB to announce a targeted response, in particular to Italy, which has seen a large fragmentation in the monetary policy transmission. We expect the ECB to step up its QE, ISIN limits and even more deviations from capital key, with a total envelope of at least EUR500bn (or reactivate the SMP programme) when the BTP-Bund spread hits 350-400bp, which we expect in coming days.

Targeting the measures

The ECB was quite clear in its targeted response last week, focusing on the liquidity and credit element in markets, as it did not cut rates. While we still do not rule out a rate cut, this is not our base case. However, with the recent miscommunication from the ECB, from both Christine Lagarde last Thursday and Robert Holzmann this morning, we need a strong commitment in terms of action from the ECB to contain this situation with significant spread widening.

Since the press conference where Lagarde made her by now famous quote, ‘we are not here to close spreads', Italian 10Y yields have more than doubled to 2.75% and German Bunds have risen almost 50bp to stand at -27bp. BTP prices are in freefall (yields up). Market liquidity has dried up completely in certain market segments, where bid-ask spreads have widened substantially and monetary policy transmission is broken. As such, we believe the ECB needs to step in urgently and do ‘whatever it takes'. We argue for a QE scale up with ISIN limits, more flexible QE implementation or an SMP programme when the BTP-Bund spread hits 350-400bp in coming days. We see the flexible capital key implementation as too restrictive in the current environment.

In short, to respond to the Italian surge in yields, fragmentation in the government bond market and repair the transmission of monetary policy, we expect the ECB to present a QE envelope of at least EUR500bn. We believe such a bold commitment would be enough to contain the credit risk associated with the government bond market. In our view, ISIN limits should rise to at least 40% and more likely 50%. We do not expect the ECB to commit to a monthly pace at this stage, with a view to implementing the package no later than in the coming year. The communication style is likely to be similar to last week's QE communication.

How to address the Italian situation?

With the situation rapidly evolving in Italy and European government bond (EGB) markets, we need the ECB to step up its efforts to contain the credit element across the EGB. In particular, we believe Italy and the ECB should essentially ask themselves how they can remove the credit risk from Italy. Therefore, we believe any measure should be targeted at this but formulated in accordance with the price stability mandate (which is currently irrelevant if monetary policy transmission does not work). We do not cover all the elements in the table above but mention a few highlights.

Increase in APP volume

Last week, the ECB announced an additional EUR120bn envelope to address the surge in the credit element on the back of COVID-19 concerns. Unfortunately, the size of the package is very underwhelming given the situation. If we assume that ECB will implement 60% of the EUR120bn in the PSPP programme by year-end, this would allocate only EUR13bn extra to Italy on top of normal APP purchases, which, in our view, is not enough to contain the situation. In our opinion, a scale up of QE would be an easy solution but with ISIN limits binding, this would require a lifting of these too. This said, increasing QE volume would not target the problem at hand, as only around 18% of PSPP purchases would go to Italy (capital key).

Lifting ISIN limits

In our view, lifting ISIN limits would be a relative easy fix and a strong signal. The ECB has already lifted ISIN limits on CAC holding bonds on a case-by-case basis from 25% to 33%. We believe lifting this again could and should be done, as it would serve as a signal to markets that the ECB would buy a significant volume ahead and ensure its presence in markets. Right now, we estimate that the ECB can buy German bonds until early 2021 (assuming no increase in issuance but with the limited proposals of additional funding, it would not alleviate the ISIN limit pressure). In our view, lifting ISIN limits to, for example, 50% would not be as forceful as deviating consciously from the stock capital key.

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