A Complete Preview Of Q€ — And Why It Will Fail

To be sure, we’ve written quite a bit lately about the ECB’s upcoming plunge into the world of 13-figure debt monetization (or as we call it, Draghi’s Waterloo), and while we hate to beat a dead horse, the sheer lunacy of a bond buying program that is only constrained by the fact that there simply aren’t enough bonds to buy, cannot possibly be overstated. 

Among the program’s many inherent absurdities are the glaring disparity between the size of the program and the amount of net euro fixed income issuance and the more nuanced fact that the effects of previous ECB easing efforts virtually ensure that Q€ cannot succeed. On the latter point, even though negative deposit rates and miniscule yields limit banks’ options for what they can do with the proceeds from any EGBs they’re willing to sell to the ECB, they could of course choose to do the unthinkable and actually make loans. ECB chief economist Peter Praet is pretty confident banks will be forced to do just that if they want to maintain margins (which have ironically been crushed by the same type of policies that the ECB is set to roll out): 

“...as expected returns on securities will be compressed, maintaining net interest income will require banks to shift their portfolios away from securities and towards loans to firms and households.”

However, this simply isn’t going to happen for the same reason other attempts to pump money into the system haven’t filtered down to Main Street: banks are too scared to lend and a tougher regulatory regime is reinforcing their reluctance. Here’s Bloomberg: 

The incentive to lend created by lower returns on securities runs into the Basel III regulatory framework. The new rules, which aim to make banks resilient to shocks, mean banks must set-aside more capital for loans. The cocktail of Basel III and QE therefore poses a dilemma for banks: either continue to hold cash and sovereign bonds, both are liquid assets and have a zero percent risk-weighting, or lend to the real economy in return for higher interest payments but lower liquidity and capital ratios.

To the extent that banks will make a profit when they sell their sovereign bond holdings, there may be a bit of extra capital floating about to make new loans. However, given the regulatory context, the chances of a big boost to lending are slim.

This dynamic is exacerbated when you consider the dramatic increase in NPLs that has occurred across the currency bloc over the course of the protracted crisis. 

We’re not finished yet. Consider also this knock-on effect of the supply/demand imbalance: if sellers suspect prices will go higher because they believe the ECB will be desperate to meet its €60 billion euro/month target, they’ll likely hold out, especially if some market participants get nervous about the availability of certain issues for short covering.

From FT: 

When the Bank of England and US Federal Reserve launched QE, their governments were still running massive fiscal deficits. With eurozone governments retrenching fiscally, purchases under the ECB’s QE programme will comfortably exceed net debt issuance — especially in Germany.

So to meet its target, the ECB will have to squeeze others out of government bond markets. That will be hard if bond holders are reluctant to sell, either because there is nowhere else to put their money, or they expect prices to rise further, which may then become the case.

It is [also] unclear on what terms the ECB will lend the bonds it acquires back to the market so that traders can cover sales of paper, known as “short” positions. If dealers worry they will not be able to replace bonds they offer, they may hold back from selling — or demand a higher price from the ECB.

All of this is compounded by the fact that no one really knows how the hell this is actually going to work (logistically we mean). The mechanics simply have not been spelled out and while Hank Paulson will probably tell you that the whole reason you wield a bazooka is so you don’t have to explain the details, the market is starting to get nervous. For as Bloomberg explains, there are many unanswered questions, including “how much the Frankfurt-based central bank will spend on each class targeted, as its monthly budget will include existing programs to buy covered bonds and asset-backed securities, as well as government and agency bonds [and] will these be conducted via reverse auctions, like the Federal Reserve did, or on the secondary market, as ECB has done previously?”

Thankfully, Morgan Stanley is here to help shed some light on the subject, although in the end, we can’t say we’re any more convinced that, to use Citi strategist Matt King’s words, another trillion can possibly make any difference when it comes to stimulating inflation (and ultimately demand), when 5 trillion has failed to do the trick thus far. 

The good news is, issuance is off to a good start. 

From MS: 

So far, euro area sovereigns have issued a total of €192bn of paper in January and February i.e. 24% of estimated 2015 target of €814bn. This is higher than the past five years’ average issuance of 20.5% as of end-February. Gross and net issuance for February stands at €86bn and €46bn, compared to the average (2010-14) of €83bn and €64bn, respectively. 


Comparing the funding progress on a country basis: Running ahead of schedule: With Ireland’s second syndication and Portugal’s 5y tap in February, they have already completed 62% and 52%, respectively, of funding target and are running significantly ahead of schedule (Exhibit S1).  Keeping on track: Belgium and Italy have completed ~27% of issuance, slightly higher than average. The Netherlands is running slow but is likely to catch up post the 10y DDA in March.  Laggards: Austria (ZH: There’s probably a Heta joke here somewhere, but we don’t want to get sidetracked) and Finland are still lagging behind while Germany, France and Spain are in line with average.


...and now for the scary numbers (i.e. the part where we again delve into just how ridiculous this monetary policy adventure truly is in the context of things like gross issuance and, even better, GDP):

Looking to March, the ECB bond purchase programme will have the largest impact on supply/demand dynamics. To place the scale of the programme in context, the ECB’s €1,140 billion purchasing programme equates to 12% of euro area GDP and 14% of the domestic bond market. Although this compares relatively favourably with the US and Japan in terms of the percentage of the bond market, it is somewhat short in comparison to GDP. Given that the purchases will take place over two years, the percentage of gross annual issuance (54%) is similar to other schemes, but the ECB purchases are the highest in terms of net issuance.

So the ECB is monetizing over half of gross issuance (and more than twice net issuance) and a cool 12% of eurozone GDP. The latter figure there could easily rise if GDP contracts and Q€ is expanded, a scenario which should certainly not be ruled out given Europe’s fragile economic situation and expectations for the ECB to remain accommodative for the foreseeable future. In fact, the market is already talking about the likelihood that the program will be expanded/extended.

From Citi: 

Additional stimulus will probably be needed; expect policy to remain accommodative for long time, most likely beyond Sept. 2016

ECB would probably be ready to loosen in near term if growth prospects don’t improve, most likely via deposit-rate cut (ZH: so even further into NIRP)

From Credit Agricole: 

Don’t expect ECB to taper bond purchases any time soon

From UBS: 

Should 2017 inflation forecasts show inflation still  isn’t back to target, this could be interpreted as indication that ECB is positioning itself toward extending QE beyond Sept. 2016

Likelihood of QE being extended beyond Sept. 2016 “is not small” 

 Here’s what purchases under the program look like on a country-by-country basis. 


...and here’s a more complete breakdown from Deutsche: 


As for the distribution of the monthly €60 billion, here’s MS’ projected breakdown:
So there you have it, a roadmap of just how and where the ECB will spend more than €1 trillion. If history is any guide however, all of this will ultimately be for nought at least as it concerns boosting inflation and demand, for as Citi has shown, if anything, QE isn’t doing much for inflation expectations (and may actually be producing deflation): 

Reinforcing this point, here’s a look at the market’s pricing of inflation versus MS economists’ projections: 

Enough said.