ECB to announce government bond purchases in Q1

Following dovish comments from a number of prominent ECB members, a continued decline in the oil price and an expected weak take-up at the December TLTRO tomorrow, we now expect the ECB to announce sovereign bond purchases in Q1 (previously, we expected it to expand its purchases to corporate bonds in January, followed by government bonds in Q2).

Yesterday evening, the ECB’s chief economist, Peter Praet, held a very dovish speech, where he strengthened our impression that the ECB will go down the QE path. Praet clearly supported Mario Draghi’s dovish stance at the ECB meeting last week while he also argued for a larger impact on inflation expectations of government bond purchases in the same way as Draghi did in a speech in November.

Yesterday evening, the ECB’s chief economist, Peter Praet, held a very dovish speech, where he strengthened our impression that the ECB will go down the QE path. Praet clearly supported Mario Draghi’s dovish stance at the ECB meeting last week while he also argued for a larger impact on inflation expectations of government bond purchases in the same way as Draghi did in a speech in November.

Praet said, ‘normally, any central bank would prefer to look through a positive supply shock, but we may not have that luxury at present’. In our view, the speech gave the most detailed case yet on the justification and mechanism of expanding asset purchases to sovereigns.

In addition, the ECB’s Governing Council member Jozef Makuch said yesterday that most ECB policy makers favoured QE at the ECB meeting last week. Hence, it seems that Draghi is waiting to gather a broader consensus for government bond purchases although he has said the ECB does not need unanimity to undertake this. In our view, Draghi will continue to argue that ‘not to pursue our mandate would be illegal’ and we believe the ECB will announce a broad-based QE programme in Q1.

Tomorrow, we expect the take-up on the December TLTRO to disappoint as we look for a take-up of EUR120bn, which should bring the total for the first two TLTROs to EUR200bn out of the EUR400bn eligible. Without a broadening of the ECB purchases, we expect the TLTROs to be the main contributor to the expansion of the ECB’s balance sheet towards the level seen in 2012. Hence, we expect a disappointment to lead to more easing and now expect the ECB to announce government bond purchases in early 2015.

Another argument for our changed view is that the oil price has continued to decline during December. This implies that we now expect inflation to decline to 0.0% y/y in December and we see it as increasingly likely that euro inflation will dip below zero in coming months. As Praet said yesterday, the ECB may not have the luxury of looking through this currently.

Monetary easing should follow although euro area leading indicators have shown the first signs of bottoming recently and we expect higher growth in coming quarters. This follows as the ECB’s mandate is to keep inflation below, but close to, 2% over the medium term.

A significant balance sheet expansion supports lower EUR swap rates sub 5Y as money market fixings will decline. One of our top trades for 2015 is to receive 3Y EUR swaps spot. We still like this idea. Richer EUR liquidity should also push down the EUR/USD CCS basis 0-5Y further. However, it might be wise to wait until after tomorrow’s TLTRO announcement as we expect it to disappoint. A significant QE programme in government bonds should compress the government curves further and lead to a steeper 10Y/30Y EUR swap curve. However, it is too early to be positioned heavily in these trades, as the market is currently rattled by Greek political tensions, the sharp drop in oil prices and a general decline in liquidity ahead of the New Year. However, these trades should do well next year.

We expect EUR/USD to decline further in coming months on the divergent monetary policy outlook and we target the cross at 1.22 in 3M and 1.20 in 6M. However, given that the ECB is expected to frontload the balance sheet, expansion risks are likely to be that the cross temporarily undershoots compared with our 6M target of 1.20 and that this level could be reached earlier than we project. We prefer to express this view in Danske Bank’s FX trading portfolio via a long USD/CHF position and this is also one of our 10 FX Top Trades for 2015. On a six- to 12-month horizon, we expect EUR/USD to bounce supported by improved growth and inflation outlook in the Eurozone. We target EUR/USD at 1.23 in 12M.