ECB Preview: Another Massive QE Expansion Coming

As the Eurozone continues to battle with the fallout from the COVID-19 crisis, market participants continue to expect the ECB to unveil further support measures on top of the wave of stimulus announced since March.

As NewsSquawk writes in its ECB preview, with rates set to be left on hold, focus will be placed on any expansion to the Bank’s Pandemic Emergency Purchase Programme (PEPP) whose purchases the ECB revealed for the first time this week. The PEPP currently has a total size of EUR 750bln, however, consensus expects this to be increased at some point. Most analysts expect a EUR 500bln increase this week as part of a pro-active strategy. Others suggest that it could be more prudent for the ECB to hold fire for now, although with an expansion largely priced in any lack of action by the central bank will likely have an adverse market impact. Other potential policy measures include extending the duration of PEPP into next year, purchases of “fallen angels” bonds and expanding the current tiering exemption multiplier of 6x.

PRIOR MEETING: The latest policy announcement from the ECB saw policymakers opt to stand pat on rates once again. Instead, the Governing Council decided to sweeten the terms of the existing TLTROIII operations and launch a new series of non-targeted pandemic emergency longer-term refinancing operations (PELTROs). Those hoping for an expansion of the pandemic emergency purchase programme (PEPP) were left somewhat disappointed with the current envelope left at a size of EUR 750bln, whilst the asset purchase programme (APP) will continue to run at a monthly pace of EUR 20bln. That said, the Governing Council was explicit in informing market participants that it “is fully prepared to increase the size of the PEPP and adjust its composition, by as much as necessary and for as long as needed”. At the accompanying press conference, Lagarde provided a relatively cautious introductory statement, as expected, whilst stopping short of specific forecasts on the macro outlook. Heading into the announcement some desks had speculated about the possibility of yield curve control (YCC), on which, Lagarde stated, the combination of tools the ECB is currently using enables it to operate across the entire curve; but noted the ECB will use all the flexibility that it has.

FISCAL EFFORTS: A key theme of the Lagarde Presidency has been calling for greater support from fiscal authorities. Last week saw news that the European Commission is to mobilize EUR 750bln for the European Recovery Fund, comprising EUR 500bln in grants and EUR 250bln in loans, and the European Commission is to propose an EU budget worth 1.1tln along with the Recovery Fund. Judgement from the ECB at this stage will likely be reserved given that the proposal is yet to be signed off by EU leaders, with leaders from the “Frugal Four” (Netherlands, Austria, Sweden, Denmark) set to seek negotiations on key aspects of the plan, particularly the grants/loans component. That said, President Lagarde will likely take note of the proposal and thank the Commission for its efforts, noting that such a fiscal initiative is required in order to kickstart the EU recovery.

RECENT DATA: The May CPI release saw Y/Y CPI fall to 0.1% from 0.3% which marked the smallest increase in price growth since June 2016. The headline was largely suppressed by declines in energy prices with core and super-core readings showing more resilience, residing at 1.1% and 0.9% respectively. Elsewhere, given the fluidity of the current situation, timelier “soft” indicators have been of greater focus for the market. May’s Flash EZ Composite reading rose to 30.5 from 13.6 (Exp. 25.0), which, although was an increase from the prior, remained firmly in contractionary territory and prompted Markit to forecast a Q2 GDP contraction of around 10% vs. Q1. Other sentiment indicators have seen EZ Consumer Confidence at -18.8 in May with Economic Sentiment at -67.5 and services falling to -43.6 despite the easing of some lockdown measures across the bloc.

RECENT COMMUNICATIONS: Notable interjections from the central bank have included recent comments from President Lagarde who cautioned that the Bank’s ‘mild’ growth scenario that looked for a 5% contraction in GDP this year has become outdated. Lagarde added that growth is likely in the range of the medium and severe scenarios which look for an 8% and 12% contraction respectively. Earlier in May, the President stated that the Bank will play its full part within its mandate and emphasized that there should be no undue constraints on ECB policy. Last week, Bank of France Governor Villeroy was explicit in his support for further easing, suggesting that the ECB has room to act “rapidly and powerfully”, adding that the Bank can be even more open regarding the flexibility of its PEPP. Elsewhere, Germany’s Schnabel left the door open to further easing by stating that ““If we judge that further stimulus is needed, the ECB will be ready to expand any of its tools in order to achieve its price stability objective”.

GERMAN CONSTITUTIONAL COURT RULING: On May 5th, the German Constitutional Court found that the ECB’s Public Sector Purchase Programme (PSPP) did not violate the prohibition on monetary financing but did rule that the programme did not respect the “principle of proportionality”, suggesting it went too far with its mandate – thus violating German law. As such, the court issued a three-month ultimatum to the ECB to demonstrate proportionality or the Bundesbank "may no longer participate in the implementation and execution of the ECB decisions at issue". In response, the ECB stated that it takes note of the German court ruling and remains fully committed to its mandate, adding that the EU Court of Justice ruled in December 2018 that it was acting within its price stability mandate. Since then, ECB policymakers have been resolute in their stance, with Germany’s Schnabel stating that she does not think it will come to the situation whereby the Bundesbank will be ordered to stop purchasing German bonds. That said, source reports last week indicated that the Bank is working on a contingency plan to carry out PSPP even without the Bundesbank.

RATES: From a rates perspective, consensus looks for the Bank to stand pat on the deposit, main refi and marginal lending rates of -0.5%, 0.0% and 0.25% respectively. At the March meeting, officials resisted market expectations that had priced in a 100% chance of a 10bps reduction to the deposit rate and since that meeting, rhetoric from the Bank has done nothing to indicate that a further adjustment lower could be on the cards. As a guide, markets currently have around 5bps of further loosening priced in by year end.

BALANCE SHEET: With rates expected to be held at current levels, focus will be on any tweaks to the Bank’s bond-buying remit with the Pandemic Emergency Purchase Programme (PEPP) currently amounting to a total size of EUR 750bln. Desks are broadly in agreement that the size of the programme will need to be expanded at some stage, however, the timing of any potential adjustment remains a sticking point. Analysts at ING look for a EUR 500bln increase in the PEPP this week on the basis that a pre-emptive move could dent unwarranted speculation in markets, as well as “the German Constitutional Court gives the ECB freedom in any tailor-made or event-related action”, something which the Dutch Bank suggests could make the PEPP more attractive for the ECB given the questions surrounding its traditional APP. Additionally, ING posits about the possibility of the inclusion of “fallen angels” in the PEPP. Morgan Stanley also look for a EUR 500bln increase this week, whilst suggesting that if the ECB are looking for a further EUR 500bln increase at the end of the year (in the event that the PEPP is extended for another year), there is a chance that they could “go the whole hog now” and come to market with a EUR 1trl increase this week. Taking a differing view, analysts at UBS believe that policymakers will wait until the July 16th meeting, at which point the programme will be expanded to a total size of EUR 1trl, with the ECB also having to provide details over its reinvestment policy at some stage. UBS notes that the ECB will likely hold fire for now on the PEPP on the basis that purchases currently amount to EUR 240bln of the EUR 750bln and thus the programme still has some room to run. Furthermore, in the absence of the Bundesbank issuing its “proportionality” report by the time of the June meeting, the ECB will wish to avoid the impression that it is forcing the German central bank to defy the German court ruling. Additionally, policymakers could also wish to buy time and wait for the outcome of negotiations on the EU recovery fund with the so-called “frugal four” likely to oppose elements of the EUR 750bln proposal. Another aspect to consider is the ECB’s reinvestment policy for PEPP, however, Morgan Stanley believes that on balance, it is too early to clarify the exit strategy at this stage, albeit MS ultimately expects full reinvestment at least for an extended period after the programme ends.

ECONOMIC ASSESSMENT: This week’s meeting will also be accompanied by the latest round of macro projections from the Bank which will inevitably see a downgrade to the current 0.8% GDP forecast for 2020; note, the ECB appear to be guiding for a contraction of between 8 and 12%. Greater focus instead could be placed upon the 2021 and 2022 expansions for insight into how quickly the ECB expects the EZ economy to recover; forecasts currently stand at 1.3% and 1.4% respectively. UBS suggests that 2021 could get an upgrade to 4.6% and 2022 be raised to 2.9%. Inflation forecasts are set to be downgraded from 2020 through 2022 with UBS providing the following expectations: 2020 lowered to 0.4% from 1.1%, 2021 cut to 1.0% from 1.4% and 2022 reduced to 1.4% from 1.6%. Note, the ECB could opt to publish various economic scenarios, rather than its traditional specific yearly forecasts.

Below we share the always insightful ECB cheat sheet from ING Economics, whose base case is also an increase in the PEPP by €500BN to €1.25 trillion.

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In his preview of the ECB's latest policy action, Saxo Bank's head of macro analysis, Christopher Dembik writes that he is onside with consensus in expecting an increase of the PEPP of EUR 500bn and its extension until 2021. The ECB is also likely to take note of the most recent data and downgrade its macroeconomic projections for this year. Any explicit reference to long term deviation from capital keys would be very welcome by market participants as it would signal that the ECB is ready to show flexibility over time to help countries most affected by the crisis and to avoid a widening of sovereign spreads.

The ECB systemic stress indicator initially developed by Hollo, Kremer and Lo Duca in 2012, and based on fifteen financial stress measures, points out that further support from the ECB is needed to limit financial issues that could slow down the recovery. Though it has receded from its annual peak reached in mid-March, it remains in risk-zone territory at 0.25. To address ongoing tensions and absorb all the new coronavirus debt issued by euro area countries, we expect the ECB to increase the size of its new Pandemic Emergency Purchase Programme (PEPP) from EUR 750bn to EUR 1.25tr and extend it beyond 2020, at least until June/September 2021.

Following the release of the worst euro area GDP figure on record in Q1 (at minus 3.8% QoQ) and given the second quarter print will be even worse due to the impact of strict lockdown, the ECB is likely to downward its macroeconomic projections for 2020. One month ago, the ECB presented different growth scenarios, with GDP contraction reaching -5% to -12% before a rebound in 2021 between +4% to +6%. We think the baseline growth forecast should be close to the most severe scenario, around -10% this year. The amplitude of the rebound in 2021 will be highly dependent on fiscal policy and the steady implementation of the EU recovery fund worth EUR 750bn presented last week by the EC. In this regard, uncertainty remains since the political bargaining between member states has just started. Thought it is a positive step forward, this is not the “Hamilton moment” expected by many European enthusiasts. It is ill-timed – the peak of the stimulus package will be reached only in 2024! – and it is insufficient in terms of amounts allocated to cope with the economic disaster, especially in countries most hit.

During the press conference, any explicit reference to long term deviation from capital keys could be bullish for the market. It would constitute a clear signal that the ECB is eager to show flexibility in running its PEPP and is committed to do whatever it takes to avoid a widening of euro area sovereign spreads.

We cannot exclude the possibility the ECB could give indications of increase in supranational bonds purchases, whenever it will be the right time, in order to absorb debt issuance linked to the EU recovery fund. It would also have the advantage of mitigating issuer limit since the relative share of sovereign bonds would automatically decrease.

Finally, as it clearly appears the initial shock from the COVID-19 outbreak is mostly deflationary, the ECB could put back on the table the topic of the inflation target that is initially part of its strategy review. A more symmetrical inflation target of, say, 1.5-2.5% in the medium run with a goal to average 2% in the long run, could be clearer and simpler than the current definition. It would also substantially reinforce the credibility of the ECB’s forward guidance in order to address growing deflationary risks.

ECB Post-pandemic policy options:

In case further monetary policy easing would be needed in the long run, the ECB is not running out of ammunition. Below, we have ranked the potential new measures from most likely to least likely to occur:

Lower TLTRO rate: TLTRO is one of the most powerful tools in the ECB toolbox. It is the least politically sensitive – the latest ECB minutes showed broad support to TLTRO – with the biggest positive economic impact and little or no stigma attached. Further TLTRO cut is on the top of the agenda if the ECB needs to act further.

Bank loans purchases: The ECB can also decide to buy private assets. Purchase of bank loans (corporate loans), as the Federal Reserve is doing with the Main Street Lending Facility, could be one option to encourage banks to give money more freely to businesses in need of a loan and free them of most of the associated risk.

HY purchases: The ECB might need to include HY bonds in its PEPP, focusing primarily on fallen angels, if the euro area faces a wave of credit downgrade in the coming months as the real impact of the crisis will be more visible.

More negative rates: Unlikely due to the negative consequences on banks’ profitability.

Yield Curve Control: It is mostly an exit strategy in case the ECB would like to run the economy hot when the recovery will materialize while preventing yields from rising too fast. The incremental approach could consist in targeting front-end yields (i.e. up to two years) to make sure borrowing costs would remain low. However, it faces both technical and legal constraints. YCC can work fine in true monetary unions, like the U.S. or Japan, but in the euro area it would imply that the ECB targets several yield curve simultaneously  - which would seriously complicate the task. On the top of that, the ECB is legally bounded to buy assets provided that it respects principle of proportionality – which would not be the case with YCC.

OMT programme: It is still part of the toolbox, but it is a last-resort measure that could be activated only in case of an unexpected and sudden credit crunch that would limit member states’ access to public markets.