Two days into Mario Draghi’s PSPP we noted that talk of a “taper tantrum [14]” had already begun. Essentially, Citi looked at what it would mean for supply if the ECB lifted the issue cap to 50% on non-CAC bonds and expanded the list of eligible SSAs. Their conclusion:
Despite the agency and non-CAC bond options, some core NCBs may not be able to fulfill their QE quota. In that instance, we see the following evolution of events:
The core NCB quota is moved to the semi-core/periphery to prevent the effective tapering of QE. This is made more practical buy the localization of risks.
If that proves too controversial, perhaps with an eye on the German constitutional Court, then the ECB could move to cutting the depo rate further to maintain loose financial conditions and especially to prevent a taper tantram forcing EURUSD higher.
Now, not even a month into Q€, some analysts seem to believe that the ECB will begin to scale back its asset purchases as early as the end of this year. Here’s Reuters [15]:
An upturn in growth or inflation, a dramatic rise in asset prices and a scarcity of bonds have all been cited as factors that could prompt the ECB to "taper" its purchases.
"We expect the ECB will decide to cut back its bond purchases as early as the second half of this year," said DZ Bank analyst Hendrik Lodde, adding the economy could improve towards year-end.
ECB insiders say that so far there has been no discussion among policymakers of tapering QE and Draghi told the European Parliament last week he believed a recovery in inflation depended on full implementation of the programme.
Some analysts say evidence of the tapering debate may at some point emerge in the minutes, or accounts as the ECB calls them, of its policy meetings, the latest of which are published on Thursday.
Unlike the QE programmes initiated by the U.S. Federal Reserve in 2008 and the Bank of Japan in 2013, the ECB's has been launched with a "tailwind" of improving economic data.
On launch day, the ECB lifted its growth forecast to 1.5 percent for 2015, from a previous 1 percent and said inflation would rise from zero this year to 1.8 percent in 2018.
Since then, euro zone data has generally beaten forecasts. Business activity this month was its highest since May 2011, and inflation is expected to nudge back into positive territory after months of declines.
Of course, if we do get a “taper” in Europe it’s far more likely to come as a result of the program’s structural deficiencies (i.e. PSPPs rules may prove prohibitive when it comes to full implementation) than it is from Mario Draghi suddenly coming to the realization that breaking eurozone money markets by commandeering every piece of high quality collateral he and the various EU NCB chiefs can get their hands on is probably not the best idea when it comes to promoting stability.
In other words, the notion of a “forced taper” seems more feasible than the central bank voluntarily winding down a program it took years to build support for. As we’ve discussed previously, one of the paradoxical aspects of PSPP is that the more successful it is in terms of driving down yields, the less assets there are to buy due to the depo rate floor (ECB won’t buy anything yielding less than -0.20%). Combine this with the fact that planned purchases already exceed net issuance in an environment where austerity pressures weigh on fiscal policy, and it’s still unclear if the ECB and NCBs will be able to hit their purchase targets especially if the program needs to be expanded because it, like Japanese QE before it, fails to have the desired effect on inflation expectations. Here’s more from Barclays:
Fed asset purchases occurred in periods of fiscal stimulus and large budget deficits, the net result being that they never outpaced the net supply of USTs and MBS. Europe, in contrast continues to pursue a policy of fiscal tightening, and we estimate that PSPP will outstrip net supply by €840bn by end-September 2016. Thus, fixed income yields are likely to feel a more enduring pull from PSPP; our rates team believes that 10y Germany could briefly turn negative depending on the evolution of economic data.
[16]
What can go wrong? If inflation (or inflation expectations) fails to improve in Europe, the ability of the ECB to enlarge the purchase programme could be called into question. This underpins our general underweight view in peripheral corporates at current tight spreads.
Of course the ECB may also be forced to consider a taper to head off the possibility that large scale purchases are, as we contend, breaking euro money markets. Here’s what JPM had to say on the subject [17]:
“The ECB has the provision that "in case the envisaged amounts to be purchased in a jurisdiction cannot be attained, national central banks will conduct substitute purchases in bonds issued by international organisations and multilateral development banks located in the euro area. These purchases will be subsumed under the 12% allocation to international organisations and multilateral development banks, which will be purchased by some national central banks". While this provision gives some flexibility to the ECB, we note it risks transmitting liquidity impairment from one jurisdiction to another. Raising the issue limit to above 25% for certain bonds or cutting the depo rate to more negative territory are possible options by the ECB as mentioned by our fixed colleagues, G. Salford section in this week’s GFIMS. But again this only shifts the market liquidity problem from one bond segment to another and risks making the ECB chasing its own tail, in our view.In all, we note the above analysis challenges the ability of the Eurosystem to meet its quantitative target without distorting market liquidity and price discovery."
Besides, as the following graphic from Citi shows, lifting the non-CAC limit to 50% doesn’t necessarily buy the ECB that much room:
[18]
And on the shift to SSA replacements, SocGen is out warning that the ECB may already be pushing investors out of the space:
However, the lack of interest from EUR-denominated accounts is no doubt linked to the implementation of the PSPP. By squeezing spreads so much, the ECB is crowding investors out of the sector.
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So while we doubt that the ECB will, of its own volition, elect to scale back PSPP out of a highly uncharacteristic respect for sanity and prudence, there are a variety of factors which could lead to a forced taper including a sudden realization that market distortions have become untenable or a lack of supply even if the non-CAC issue cap is raised and substitute SSA purchases are made. To be sure, a “forced” taper would be very bad perceptually as it would serve to validate the market’s fears that in the event inflation expectations remain muted, the central bank will quite literally be out of options.
Here’s SocGen once again, to sum it up:
The major risk to that view is that the ECB, at some point, could scale down the programme on evidence that it is causing excessive distortion in the euro bond markets. What will happen once the ECB has grabbed the low hanging fruit and it becomes more difficult to find sellers of bonds this summer? Breaking the 25% cap for non-CAC issues, expanding the universe to corporate bonds or scaling back the programme all are possible options.
