The ECB 'Compromise' Cheat-Sheet
With Bernanke leaving the door open, but not pre-committing, in a check-raise to Draghi next week, market focus remains almost exclusively on the bond-buying program to support Spain. Credit Suisse expects markets to be mildly disappointed by Draghi's words and deeds as they question how far he can go, and in terms of near-term market moves, how much is said at next week's meeting versus said at later occasions or indicated through actions (e.g. once Spain asks for help). Draghi has already started to manage expectations with his Die Zeit comments (pitched at the German populous) but in order to get a handle on what the various scenarios are - and what the implications could be - here is Credit Suisse's matrix of compromise.
Credit Suisse: Analysing the ECB scenarios
Exhibit 6 below shows the main scenarios we consider possible. Our central scenario is the Compromise Scenario where the ECB cuts the Repo Rate to 50bp, keeps the Deposit Rate at 0% and revises the collateral framework. We expect little new material information on the front end SMP bond buying program. To us, this will underwhelm market expectations and will lead to a modest rally in core markets.
But the fact that the ECB meeting may well disappoint on bond purchases at this meeting does not change our constructive view on 1y Spain and Italy. In fact, any disappointment-led widening in 1y Spain would ultimately provide an opportunity to add to longs in 1y (and longer if it is clear that there will be buying) bonds; i.e., the commitment to do something is clear enough, it’s just a question of timing.
In developing these scenarios, there are three main axes to consider. We delve into these in more detail below:
- Front-end bond buying: the degree of detail we get next week will determine the tone of the market in the near term. The question of seniority remains key.
- Revision to the collateral framework: we are expecting changes to the collateral framework. Reducing haircuts will effectively act as a Repo rate cut.
- Policy rate cuts: we do not expect negative Deposit Rate in the near future. We expect the ECB to cut the Repo rate by 25bp to 0.5%.
Disappointment. Under this scenario, the ECB does not provide any new material information on the front-end bond buying program. The ECB does not cut the Repo Rate but only announces the revised collateral framework. We expect the lack of detail on the bond buying to support a rally led by the Bund. The front end can sell off (5-10bp) as the market readjusts expectations for a Repo Rate cut. Spain and Italy 2-3y are likely to underperform in this scenario.
Compromise. Our most likely scenario. We expect little or no new information on bond buying. We expect a modest rally in core markets and wider peripheral spreads. To us any sell off in the front ends of Italy and Spain are a buying opportunity as we expect the ECB to reinforce their willingness and ability to address current market fragmentation.
Positive. In this scenario, we expect a meaningful revision to the collateral framework, and specific details on the maturity and countries that will be included in the front-end bond buying program. We would also expect the ECB to convincingly address the issue of seniority of bond purchases. To us that would be positive for the periphery. We expect tighter soft core and peripheral spreads. German yields would shift higher. We would position for this scenario by being short core yields.
Extremely positive. The least likely outcome. This scenario involves revision to the collateral framework that is immediately positive to the periphery (e.g. reducing haircuts on government bonds to a flat structure). The ECB cuts the Repo rate to 50bp and keeps the Deposit rate unchanged at 0%. Additionally, the ECB announces yield caps on the SMP program and addresses the seniority question convincingly. The immediate reaction is expected to be bearish steepening of the German 5s10s curve and tighter ASW, soft core and peripheral spreads.