We expect the European Central Bank (ECB) to leave policy unchanged at the 8 September Governing Council meeting. We do, however, expect it to ease at the 12 December meeting and, given our longer-term focus, we go into this week’s meeting with portfolios positioned for the changes we anticipate the ECB to eventually deliver.
When it eases, we expect the ECB to cut the Deposit Facility rate, extend quantitative easing (QE) and relax the capital key used for distributing government bond purchases. The policy changes that we anticipate in our baseline should lead to tighter spreads between periphery and German government bonds, tighter corporate spreads and steeper core-country yield curves.
The gap between current headline inflation (0% year-to-date average), the ECB’s inflation forecasts (1.3% in 2017, 1.6% in 2018) and its higher target justify further policy easing, in our view.
Faced with this gap, the ECB has to decide between additional easing or lowering its inflation target. We see no desire to change such a fundamental feature of the operational framework as the inflation target, and so long as the ECB’s two-year-ahead inflation forecast is less than 2%, we think that will keep the bank in easing mode.
Currently, the ECB has precommitted to buy €80bn of bonds per month until “the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its aim of achieving inflation rates below, but close to, 2% over the medium term.”
Furthermore, the latest dip in core inflation to 0.8% adds to concerns expressed in the July minutes that “underlying price pressures continued to lack a convincing upward trend and remained an ongoing source of concern,” which tilts the policy response toward additional easing. The current QE programme will amount to 17% of eurozone GDP by the time it is completed in March 2017.
Our baseline sees QE rising to about 23% of GDP by December 2017, similar to Bank of England and Federal Reserve QE levels. Tapering QE shouldn’t come onto the radar screen until the ECB’s inflation forecast two years out comfortably reaches 1.8%–2%, which looks unlikely before 2019.
How will the ECB deal with the Bund scarcity problem?
In our baseline, we expect the ECB to relax the capital key allocation for government bonds. Any extension of QE will exacerbate the Bundesbank’s problem of finding enough Bunds to buy without overly distorting the yield curve and exacerbating financial stability concerns; e.g., potentially damaging the business models of the banking and insurance sectors by flattening the yield curve, an issue that the Bank of Japan is now starting to address in the context of its QE programme.
The ECB’s purchases of government bonds are guided by eligibility criteria – some hard-coded by the European Treaty, others self-imposed. These criteria include purchasing bonds at yields above the Deposit Facility rate (-0.4%) and a 33% issuer and issue limit.
The ECB allocates total purchases of government bonds broadly in line with its capital key, and it uses government bonds as the swing factor when it cannot find sufficient agencies, asset-backed securities (ABS), covered bonds or corporates to buy.
Currently, the Eurosystem – the ECB and national central banks – buys about €18bn of Bunds per month. Were it to reduce this amount, we think it would pro rata the balance over the remaining countries, which amounts to a tapering of Bunds, especially the longer-dated ones that the Bundesbank has revealed it is reluctant to buy. Large countries – France, Italy and Spain – should be the major beneficiaries of tapering Bunds.
While relaxing the capital key will be controversial in some quarters, we think relaxing the other criteria are even more controversial. For example, purchasing bonds at yields below the Deposit Facility rate would realize a loss, which might require the ECB and national central banks to increase capital reserves and make for awkward explanations to lawmakers in the European and national parliaments.
We also think the importance the ECB attaches to independence makes it reluctant to hold a blocking minority in any issue or issuer, which, in the unlikely event of insolvency, would complicate the restructuring of sovereign debt. Relaxing the capital key is the path of least resistance, in our opinion, and also makes sense from a credit easing perspective.
Andrew Bosomworth is PIMCO’s head of portfolio management in Germany