A running theme here over the past several weeks has been that the ECB’s €1.1 trillion foray into quantitative easing will be severely hindered [14] by a laundry list of constraints (some of which were unwittingly self-imposed). Another topic we’ve covered exhaustively is the idea that the world’s central banks will likely all, in relatively short order, run up against the natural limits [15] of accommodative monetary policy (indeed, even some Japanese policy makers are starting to agree on this).
Thinking about these two things in conjunction raises an interesting question for the ECB: if a tail event comes rearing its ugly head and the global central bank race to the bottom accelerates, will Mario Draghi, effectively fighting with one hand tied behind his back by virtue of Q€’s limitations, be able to fend off an outright collapse?
Here’s FT [16] with more:
...the ECB is now close to running out of ammunition. The true constraints on further ECB intervention lie in the 25 per cent issue limit and 33 per cent issuer limit on its sovereign bond purchases.
Except for Greek debt, the 25 per cent and 33 per cent caps should not prove binding in a scenario where the ECB keeps its monthly asset purchase pace of €60bn. However, the limits could be reached in worst-case scenarios where the ECB would have to boost the size of its QE programme or implement OMTs targeted on specific sovereigns.
The first type of worst-case scenario would be a new global deflationary shock. It might be triggered by faltering US growth or a sharper-than-expected slowdown in China. The consequence would be fiercer currency wars with balance sheet expansion races among central banks.
In this competition, the ECB would be handicapped: it would not have much room to significantly increase the size of its bond purchase programme. For instance, if monthly purchases had to be raised to €100bn, the 25 per cent issue limit would be reached after only eight months in the case of German government debt.
Given the narrow size of the eurozone corporate bond market, any substantial further expansion of the asset purchase programme would then have to include equities. But this could prove controversial within the ECB governing council.
It seems to us that this “first type of worst-case scenario” is not merely possible, but in fact likely. As we’ve shown time and again, QE’s ability to stoke inflation expectations and boost aggregate demand simply has not been proven [17] — even after $5 trillion in asset purchases. Here’s what we had to say on the subject last week:
And so, stuck as we are in what looks like a chronic condition of oversupply and as it increasingly appears, in Citi’s words, that “the decoupling between EM GDP growth and global trade growth over the past decade [now looks] less like a benign shift away from exports to domestic consumption, and more like a world where GDP was temporarily boosted by a surge in credit, where suppliers ramped up capacity in anticipation of 10% nominal EM/Chinese demand growth continuing indefinitely, but where the limits of such credit-fuelled demand are suddenly being exposed,” more QE simply won’t move inflation expectations and certainly can’t do much to further stimulate aggregate demand (assuming it’s done anything in that regard thus far).
And it really hasn’t done anything. In fact, by keeping borrowing costs artificially low, QE may well be contributing to deflation by allowing insolvent producers to stay alive via cheap debt, resulting in overcapacity everywhere you look.
Furthermore, we now know that we will in fact get a sharper-than-expected slowdown in China as we just reported minutes ago (see here [18]).
FT’s second type of worst-case scenario may be even more likely to manifest itself than the first:
The second type of worst-case scenario would be the return of the redenomination risk premium in certain peripheral sovereign bonds, for instance in the event of a Greek exit from the euro becoming a serious threat.
There is little doubt that the introduction of an alternative currency in Greece would lead markets to reinterpret the euro as a fixed exchange rate arrangement rather than as an irrevocable monetary union.
If recent events have taught us anything, it’s that the return of redenomination risk can come almost overnight — just look at the past two months. Regarding sovereign bond yields, the ECB has thus far succeeded in driving periphery borrowing costs (sans Greece) to record lows as Spanish and Italian 10s trade nearly 70 bps tighter than 10-year Treasurys. Should markets begin to factor in the same kind of redenomination risk premia as they did in the summer of 2012, the ECB would be hard pressed to arrest the panic. Here’s why, via FT again:
Mr Draghi [says] the QE programme does not alleviate the need to make recourse to OMTs in order to remove this redenomination tail-risk in specific stressed countries.
However, contrary to its initial design, the OMT programme could no longer be seen as “unlimited”. In the case of Portugal, for instance, the 25 per cent and 33 per cent limits leave barely any room for OMT purchases in addition to the planned QE purchases.
Indeed, Draghi himself is already playing down Q€'s potential, noting this afternoon in Cyprus that QE alone will not be sufficient to reignite eurozone growth.
Given all of this, it seems the only option for the ECB would be to plunge further into NIRP-dom. Here’s Robert Michele, JPM’s head of global fixed income, on just how crazy the new paranormal is about to get:
Via Bloomberg, citing Handelsblatt:
Eurozone on road to deflation, and bonds remain [an] attractive asset because high demand meets scarce supply
ECB will reduce interest for cash deposits to minus 3% and the dollar [will] appreciate by 20%, reaching parity with euro in 2015
There you have it Denmark. Draghi will see your minus 75 bps and raise you negative 225 on top.
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As a reminder, here’s what the distribution of asset purchases looks like across the eurozone:
[19]