It’s nearly that time again.
On the heels of December’s “big disappointment” wherein Mario Draghi cut the depo rate by a “measly” 10 bps and extended PSPP by an underwhelming six months, the ECB meets again next week, and this time around, expectations are low.
Despite the fact that markets have descended into outright turmoil, the ECB “is very unlikely to change its QE dynamics or cut the deposit rate at the upcoming meeting,” Barlcays says. “The earliest QE tweak opportunity for the ECB is the March meeting, if at all.”
So assuming Draghi doesn’t immediately push the panic button now that sub-$30 crude is virtually guaranteed to keep the Eurozone mired in deflation, we’ll write next week off when it comes to further cuts to the depot rate of a further extension/expansion of QE.
That said, we doubt we’ve seen the end of ECB easing especially given what’s currently unfolding in markets across the globe and considering the trajectory for commodity prices. The question now is what options the ECB has considering the fact that each incremental bond purchase brings the central bank ever closer to the endgame wherein Draghi begins to bump up against the issue cap for German bunds and, depending on how long the program is ultimately extended, for Spanish and French bonds as well. That goes double in the event the ECB expands the pace of monthly purchases (i.e. if Draghi both extends and expands the program).
Here’s a table from Barclays which outlines two hypothetical scenarios. The first assumes PSPP is extended for another six months beyond March 2017. The second assumes a €20 billion expansion in the monthly pace of purchases and no extension of the program’s duration.
As you can see, in either case the ECB hits the threshold (33%) for bunds, implying that expanding and extending the program simply isn’t possible unless the EBC drops the capital key allocation.
“We think flexibility in potentially moving away from the capital ratio has a more credible chance because it would not have to happen immediately. It will likely be pitched as: if and when we hit the 33% limit in Germany, we might look into allocating the excess in German purchases to other EGBs, still according to ECB key capital rules of the remaining issuers,” Barlcays says, adding that dropping the issue cap would risk running into the CAC problem.
As for buying more covered bonds, SSAs and ABS, Barclays says the game is about up in those markets. “Liquidity has significantly worsened in asset classes such as covered bonds, agencies, supras and ABS since the launch of the asset purchase programme,” the bank notes. “As a result, the ECB might run out of bonds to buy or just find it difficult to place bonds in these universes in order to achieve its monthly target purchase amount (likely up to €20bn out of €60bn).”
In another sign that purchase eligible assets are indeed becoming scarce, Bloomberg notes that although ECB officials “say monthly purchases of about 1 percent of the bonds outstanding haven’t constricted the market, sales of ‘off-the-run’ securities by some of the region’s biggest issuers argue to the contrary.” Here’s more:
France’s AFT, which boosted the proportion of sales of such non-benchmark securities to 33 percent last year, the most since 2011, said reopenings of the less-traded debt help “preserve liquidity along the entire curve.” Germany plans to sell more of an off-the-run July 2044 security this year, the Finance Agency said last month.
“The longer QE goes on, the more that the distortion impact can be visible, and you can tackle that through these off-the-run issuance,” said David Schnautz, a director of rates strategy at Commerzbank AG, which acts as a primary dealer in both France and Germany.
Existing benchmark bonds become off the run once they’re replaced by a new similar security in sufficient size. Issuing more of the older bonds, which tend to be less frequently traded and, in today’s environment, tend to carry a higher coupon, helps expand the universe of securities available to national central banks, who carry out QE.
“If you can only buy 33 percent of the benchmark bonds, you won’t hit your monthly purchase target over an extended time period,” Commerzbank’s Schnautz said.
In other words, scarcity and liquidity are indeed problems, no matter what the Governing Council says.
What all of the above suggests is that if the ECB intends to both expand and extend PSPP while maintaining the issue cap and retaining the depo floor constraint, eventually Draghi will need to find more bonds to buy and he's not going to get to where he wants to be by snapping up a few sub-sovereigns or coaxing out off-the-run issuance in dribs and drabs.
And so, unless the ECB intends to find itself in a situation where it is forced by PSPP's many constraints to continually disappoint the market in an environment where low commodity prices are likely to cause inflation to continually undershoot the central bank's target, it's just as likely as not that the ECB will move into IG corporates next and from there, it's full-Kuroda-ahead into stocks.