After last week's stunning action by the SNB, which according to most was done in anticipation of what will be a substantial QE announcement by the ECB as the last thing the Swiss National Bank wants is to be the primary buyer of what may be up to 1 trillion in fresh minted Euros, it seems that the debate whether the ECB will act next week has become moot.
However, despite various media reports over the past 24 hours about risk-sharing and sovereign security exclusion (i.e., that of Greek Treasurys), as well as speculation that despite it being priced in more than 100%, the ECB may yet again delay the actual announcement especially with what watershed Greek elections following just days after the ECB announcement, the question remains just what format will European QE take. Here, courtesy of Credit Suisse - a bank which was pounded in the past 2 days following the record surge in the CHF - is a preview of the 4 most likely ECB scenarios, as well as a glimpse at what may be the worst possible outcome for Europe: QE itself!
From Credit Suisse:
We consider four potential scenarios for ECB sovereign bond purchases depending on 1) the degree of risk sharing and 2) the size the ECB announces. We believe the market reaction to an announcement of QE is likely to be very different depending on these two factors.
1) Small size and low risk sharing: The first scenario is a purchase programme that is below €500bn and has risk sharing below 50% of the total programme. We believe the market reaction would very negative for risky assets in general and the periphery in particular. We believe this scenario remains bullish core rates driven by the likely riskoff moves in risky assets and removal of any debt mutualisation.
2) Large size and low risk sharing: The second scenario is a purchase programme with a size closer to €1 trillion but risk sharing of the overall purchase programme still limited to a maximum of 50% of the total programme. We believe such a programme would be bullish risky assets and core rates given the upside surprise in the size. We expect a similar move in core rates as in the Japanese QQE, where the flow of purchases will trump any change in inflation expectations.
3) Large size and large risk sharing: The third scenario is identical to the second scenario in terms of size but risk sharing will be above 50% of the programme. We expect such a programme to very bullish risky assets and, in particular, leading to a strong rally in peripheral bond markets. Given the high degree of European debt mutualisation in this scenario, we expect core rates to sell off.
4) Small size but large risk sharing: The fourth scenario is equal to the first scenario in terms of size and equal to the third scenario in terms of risk sharing. We believe the market reaction in such a scenario would be bearish risky assets but peripheral markets should fare well given the higher degree of mutualisation relative to market expectations.
CS believes the most likely outcome is that the ECB announces a hybrid programme in which a certain part of the programme will be risk shared and an additional part be conducted on the own risk of the individual central banks.
We expect the ECB to do between €500-750bn with a component of that not risk shared. We expect the ECB to distribute its purchases across the curve by the outstanding amount in each maturity bucket. But there is a chance that the risk shared purchases are more concentrated to the front-end of the curve while purchases by NCBs are concentrated on the longer part of the curve. We believe this would overall have a negative signaling effect.
Some other observations in line with what has already been leaked:
The biggest positive is likely to be timing driven
Most discussions about how the ECB could surprise seem to centre on how much the ECB announces it will buy – is it more than €500bn – and what proportion is taken on the ECB's balance sheet rather than on the balance sheet of individual national central banks. Clearly a €1 trillion programme would be a more powerful market stimulant than one for €500bn, but the timing of purchases has the greatest potential to move the market in our view. There has been widespread coverage of the various sizes the ECB could buy and where the risk could sit, but consensus seems to be that while the ECB will announce something, the devil will be in the detail and most details are unlikely to be forthcoming immediately.
Few seem to believe the ECB will be able to act quickly. A purchase programme that started during the press conference, as was the case for the SMP programme, and clearly laid out the purchase structure, we believe would send the strongest signal given where market expectations are. Caveated, of course, on the need for the programme to meet basic market expectations on size and composition – activation speed cannot be a substitute for a sufficiently large programme.
The signaling effects will be key
As we mentioned last week, a number of the proposals being floated, we think, could be taken rather negatively, once the market sees past the fact there is a material new purchaser in the market. The speed at which this happens depends on the importance of the signal, but there are a few we think worth highlighting.
Rating restriction: A restriction to just the highest quality sovereigns would be a very negative signal in our view, although we deem it very unlikely. As outlined last week, we think that the ECB has to be able to buy all sovereign bonds, at least in theory, and so the most likely is that purchases cover investment grade sovereign bonds, with an exception made with some specific conditionality for non-investment grade sovereigns,exactly as in the case of the ABS and Covered Bond purchase programmes.
Risk-sharing: The market now seems to have been conditioned to expect that some proportion of purchases may not be "risk-shared" – they may sit with the national central banks, rather than with the ECB. While this may ultimately prove to be one of the conditions required to get the Bundesbank on board, we think this is a very poor signal for the periphery and could prove to be very negative, albeit maybe not immediately.
The question is whether it effectively makes any difference – is an NCB purchase really any different to an ECB purchase? If so, it risks undermining the construct of the single monetary union in our opinion, and would be clearly done with a view to be making it more straightforward to restructure another sovereign's debt – not exactly a positive for peripheral spreads.
It's not clear, however, that the market may immediately care – the initial focus is not likely to be on a future, potential, restructuring risk. And if economic conditions improve, debt sustainability may never really be in focus, in which case, the implications of the decision are unlikely to be fully considered. However, if debt sustainability does come into question for Italy or Portugal, for example, the implications we believe are very negative for peripheral debt holders, with increased likely losses in the event of a default or restructuring.
SMP holdings: We think it unlikely, but if existing SMP holdings of peripheral bonds were to be rolled into the programme and account for a proportion of the stated purchases, potentially with the commitment to roll them on maturity, we think this would be taken very negatively.
Seniority: Again, we think it unlikely that this is mentioned in any detail, but any suggestions that the ECB ranks senior would be a negative – the question is how quickly investors decide to focus on the effective subordination of their risky debt holdings, which could take some time depending on the strength of ECB rhetoric and economic developments.
Conditionality: As stated above, we expect some conditionality for sub-IG sovereigns, most likely related to being in a programme with more restrictive purchases, in line withexisting purchase programmes. This should be broadly expected in our view; very onerous conditionality that is clearly aimed at excluding certain countries' bonds we believe would be an unexpected negative.
And while we are confident that the final formulation of QE will be some variation on the above, the most important topic, and one which has seen far less debate, is that once the ECB finally launches QE, the magic of the "QE dream", in Credit Suisse's words, will finally die as the market wakes up from a nearly 3 year-old-long slumber under the hypnosis of Draghi.
In fact, it could well be the case that to preserve the "put" optionality, the ECB will actually defer acting yet again, thus sending risk even higher and yields even lower! To wit:
On the downside, no announcement would clearly be a market disappointment given all the recent headlines from ECB members, however, it isn't so clear that this would be a large rates-market event. If the ECB isn't in a position to announce a purchase programme, then at the very minimum we would expect Draghi to firmly keep the QE dream alive. Arguably, as we discussed last week, the dream may prove far more powerful as a market driver than the reality, but importantly as we've seen in recent months, it is very hard to trade against the possibility that QE may well be coming down the pipeline in the near future. So while an announcement is clearly not now expected, it probably wouldn't have a lasting market impact unless the messaging is very muddled.
Then again, nearly three years after "whatever it takes", most are convinced that Draghi has taking talking the talk as far as he possibly could have. So if the QE magic is indeed ending, what happens next? Some thoughts:
The resilience of peripheral spreads in the latest round of equity and commodity volatility has been remarkable. Spreads shrugged off volatility in 1) EM last year, 2) in crude oil this year and 3) in recent equity volatility. We attribute this to the power of the “Draghi put” and the threat of ECB QE. The question is whether the same phenomenon can continue once the “QE dream” becomes reality.
We expect there will be a tipping point (as we saw in 2013) where negative sentiment in other asset classes (EM, credit, European equities – especially bank stocks and inflation breakevens) will start having an impact on sentiment in the periphery. Obviously, if the ECB delays the QE decision, the feedback loop between the periphery and other risky assets should return; but calling that timing is complicated as we expect that if the ECB does not deliver QE in January, it will still keep the QE dream very much alive and kicking for the next meeting.
The market is differentiating between 1) what the ECB buys versus what it doesn’t and 2) economic versus financial asset valuations. There was a time when weakness in peripheral equities and/or bank stocks would feed through to peripheral yield spreads (see Exhibit 16), almost immediately and vice versa. But the grab for yield environment and the ECB’s backstop for spreads has broken this relationship. Current valuations, however, beg the question of when does the periphery take notice of price action in other markets.
We expect this “tipping” point to happen either when:
1) the ECB does QE but the market remains skeptical of the reflationary impact of QE or 2) the ECB delays QE and the market goes into Greek elections without tangible ECB support. As shown in Exhibit 17, peripheral spreads have diverged significantly from inflation breakevens. If QE does little to move the needle on inflation expectations, then there will come a point in time when the market questions the tightness of spreads. We are not saying that time is now – we share the consensus that ECB QE will initially be positive for the periphery and in fact, below add to our peripheral exposure – but we think this question will be asked once QE happens.
There is even a case to be made that once QE is announced and the exact details on implementation are revealed that the periphery could then become more sensitive to risk sentiment in other asset classes. While the ECB keeps the “QE dream” alive, it is harder for the market to short the QE option, but how and when that dream crystallises into reality will affect the sensitivity of Italian and Spanish yields to other risky assets. We keep our positive view on the front end (i.e., out to 7y) of the periphery, but are more cautious on extending further out these curves.
It will be truly ironic if the one event that terminally crushes the Eurozone will be the implementation of the one ECB act that everyone, and certainly tenured economists and other quasi-pundits, have been hoping for since 2012.