A Look At This Week's "Other" Big Event

With the Italian referendum now in the rearview mirror, the market's attention focuses on this Thursday's second most important event, the ECB meeting on Thursday. Here the biggest question is whether, alongside the now widely expected extension of the ECB's QE which is set to mature in March 2017, and which most analysts believe will be prolonged until at least September 2017, Mario Draghi will also announce some form of tightening or tapering of QE purchases or an eventual formal ending of its asset purchases, as Reuters hinted in a trial balloon report last week.

As readers will recall, on December 1 Reuters reported that in advance of its March 2017 meeting, the ECB was considering sending a "formal signal after its policy meeting next Thursday that the program will eventually end." It added that skeptics of more stimulus on the bank's Governing Council "have accepted that an extension beyond the current expiry date of March is inevitable given weak underlying inflation and heightened political risk."

The question remains how to structure that extension.  According to report, much of the preparatory staff work had focused on a six-month extension at a steady pace of 80 billion euros per month, an option favored by many as growth is sluggish, inflation lacks momentum and political risk from key elections keeps the chances of market volatility high, three sources said. But some have indicated they would favor an extension at lower volumes, for example nine months at 60 billion euros a month, fearing that a straight extension could make the program appear open-ended, two of the sources said.

A compromise under discussion would be to signal the program's eventual end, possibly in the bank's forward guidance, indicating that the purchases cannot be extended indefinitely. Another option is not to specify monthly purchase volumes, essentially making them dependent on economic developments, the sources said, similar to what the BOJ has done with its curve control operation. That would allow the ECB to buy up to 80 billion euros without requiring it to spend the full amount.

Of course, any formal tapering announcement could jolt the European (and global) bond market, in a redux of the infamous 2013 Bernanke "Taper Tantrum", which coming at a very sensitive stage for Europe, in the aftermath of the Italian referendum, seems unlikely.

The Reuters report laid out the tensions between the hawks, pushing for tapering, and the doves, who insist on simply extending the program as is, with perhaps some modest tweaks.

What do others think?  Below we lay out some summary scenarios as laid out by Wall Street banks:

According to Deutsche Bank, the ECB will announce a 6-month extension of the current €80bn QE programme (an extension from March 2017 to September 2017). This is likely to be complemented by a move to improve the supply of eligible bonds, perhaps by the removal or softening of the yield floor. This would facilitate a steeper yield curve and incentive transmission. In an alternative scenario DB economists believe that the market would react negatively to say a slowing in the pace of purchases to €60bn. The bank's economists have derived three rules that need to be satisfied by spot and forward core inflation in order for the ECB to taper. The soonest these are likely to be satisfied is mid-2017. They go on to highlight that if the ECB’s above-consensus view on growth is correct, the euro exchange rate depreciates in line with DB’s house view and systematic financial crisis is avoided, tapering could be announced in June 2017. On the other hand if their below-consensus view on growth is correct and the growth/inflation relationship is weak, tapering could wait until end-2017. The last thing to note is today’s market reaction to the referendum result which also has the potential to influence Thursday’s meeting actions.

* * *

According to Bank of America, the central scenario is likewise of a 6 month extension at €80bn per month via minor tweaks in the capital key. The reaction of Bunds will ultimately be more a function of the changes to the securities’ lending programmes than QE itself. For the periphery, the bank distinguishes between Italy – where the referendum and the fate of the pending bank capital raises will dominate – and the rest. BofA believes that addressing repo issues should be at the top of the ECB’s priority list. Solving the richness of GC would make a straightforward 12 m extension in QE feasible. As Bank of America notes, figuring out what is priced in has become more difficult on the back of the repo squeeze in the front-end of the German curve – and not helped by conflicting ECB rhetoric. Schatz trades at -40 bp to OIS, a new post 2008 record. The market impact of ECB action next week therefore needs to be assessed against the following:

  • Has the ECB taken credible steps to address the collateral squeeze in front-end triple-As in particular?
  • Will the QE extension involve buying less German government bonds in future?
  • Is QE extended in such a way that risk premia in the periphery can be expected to retrace or at least stabilise?
  • Does the ECB maintain a sufficiently accommodative monetary policy stance such that current levels of breakevens and forward EONIAs can be justified

The tables below summarise the bank's views on the reaction of both Bund yields and the German curve, as well as the periphery in four stylized scenarios. Its economists distinguish the different modalities of QE extensions and different approaches to the repo issues discussed in depth previously. The focus is on short-term market reactions, since it believes that a renewed commitment to large QE purchases (80bn/m for 6m) or long-term ones (60bn/m for 9am) will be a sufficiently positive surprise to the market to avoid the debate of how to assess fair value in the periphery in a world without QE.

The table below assumes a directionality in peripheral spreads. BofA believes that the biggest risk to the periphery is higher Bund yields. It therefore assumes that a flow driven repricing of Bund yields lower, will also have positive spill-over effects for the periphery.

The next table lays out what options deliver what extensions to the ECB. BofA highlights that with an effective policy addressing the richness of (German) GC, extending QE becomes very easy without  having to tackle exogenous constraints such as the depo rate floor, or indeed the capital constraint. Addressing repo issues should actually be at the top of the ECB’s priority list for next week. Solving the richness of GC should make the 4y sector available for purchase, which in combination with raising the limits on non-CAC bonds, makes a 12 m extension in QE feasible without getting into difficult political discussions (see purple cells in table below).

BofA concludes as follows: "Going into next week’s meeting, and with more than the usual uncertainty around the details of the announcement, the chosen rhetoric, the on-going repo issues, the Italian referendum and bank recap stories, we have little risk appetite."

* * *

Finally, according to UBS, the ECB will play it safe next week, and will extend QE in its current format (€80Bn monthly) for six month until Sept 2017, echoing the other two banks. UBS says that while the new staff macroeconomic forecasts for 2017-19 will form an important basis for the decision, it thinks the members of the ECB Governing Council will have to take an even more comprehensive view, evaluate the broader balance of risks, and ask themselves whether the time is ripe for a reduction in monetary stimulus. In this context, the GC will also have to consider the implications of political events, such as the outcome of the Italian constitutional referendum on 4 December and the sharp rise in global bond yields which has probably led to an (unwelcome) tightening of financial conditions in Europe. UBS currently expects the ECB to taper after September 2017, perhaps over the course of one year. The Swiss bank does not think ECB policy rates will be cut further, but rate hikes are unlikely before 2019.

UBS notes that in his recent speeches, ECB President Draghi made the case for an ongoing strong degree of monetary accommodation. Speaking in front of the European Parliament on 21 November, he said "[T]he return of inflation towards our objective still relies on the continuation of the current, unprecedented level of monetary support, in spite of the gradual closing of the output gap. It is for this reason that we remain committed to preserving the very substantial degree of monetary accommodation necessary to secure a sustained convergence of inflation towards levels below, but close to, 2% over the medium term."

The Swiss bank notes that its base case scenario of a six-month extension in QE in its current form does not mean that there will be no robust discussion about more hawkish choices, such as tapering or a reduction in the monthly asset purchases as the hawks on the GC will push for a reduction in QE, pointing to the relatively robust Eurozone economic data, rising inflation, and the weaker Euro. UBS notes, however, the conservative part of the Governing Council might be weakened on 8 December as the Dutch and Slovakian central bank governors will not be able to vote.

On the all important topic of whether the ECB will taper, UBS says that after September 2017, the time will come for the ECB to start scaling back the QE programme through tapering. The decision might potentially be taken as early as 8 June 2017 (or otherwise 7 September), along with an updated set of macro forecasts for 2017-19. As shown in Figure 1, "tapering" could take various forms, with different speeds, degrees of flexibility, and strength of forward guidance – and hence hawkishness. The base-case assumption is that the ECB would wind down the QE programme over the course of one year, from October 2017 to the fall of 2018. If and when the tapering process starts, the ECB will have to take great care not to create a major "tantrum" in the markets, with significant rises in bonds yields and losses in risk assets. Hence, the ECB will likely adopt a flexible framework where it does not commit too strongly to a pre-determined pattern of winding down QE.

Still, with inflation around the globe, if only according to various market indicators such as 5y5Y forward, ascendent around the world and in Europe, what happens if the hawks win the upper hand? The answer is shown in the following table laying out the ECB's "menu" options for monetary policy normalization and tightening.

On the topic of rate moves, UBS says that its base-case scenario implies that ECB policy rates have bottomed out, with the depo rate at -0.4%, the refi rate at zero, and the marginal lending rate at 0.25%. However, the ECB has explicitly stated that rate hikes should only be expected once the QE programme has come to an end. Assuming that QE will run until the fall of 2018, we think that ECB policy rates will remain at current levels until (at least) 2019.

UBS' Conclusion – the market has largely priced in its base case:

"we see a clear need for the ECB to act next week to maintain its accommodative stance via an extension of QE and ensure the implementation of purchases via changes to the technical parameters of the APP. In our opinion, the most likely changes to the QE design will be the removal of the deposit rate floor for QE purchases alongside an increase in ISIN/issuer limits on non-CAC bonds. These changes should be sufficient to implement QE purchases at least throughout 2017 in our view. Politically controversial adjustments to or deviations from the PSPP allocation key remain unlikely at the current stage. In general, we think the market is well priced for our baseline expectation and we stick to our views outlined in the 2017 Markets Outlook. Our strategic focus remains on steeper curves and gradually higher Bund yields. In terms of the risk scenario for next week's GC meeting, we see some risks that a hesitation or a delay from the ECB to extend QE fosters unwarranted monetary policy tightening and will lead to a deterioration of risk sentiment alongside a flattening of core EGB curves driven by the front-end. EGB spreads vs. Bunds are unlikely to be hugely supported by changes to the PSPP allocation key and remain subject to political developments with the Italian referendum being the next sign-post."

One thing to note having read all three reports is that virtually every bank is positioned exceptionally dovish, and expects virtually no hawkish surprises out of the ECB. Which means that if there is a surprise, the pain trade will be for the EUR to rise sharply higher from its recent levels, although what complicates a simple long EUR trade is today's dramatic short squeeze in EUR pairs, after expectations of a far more dire market reaction to the Italian referendum, which however did not materialize, promptly a 300 pip move higher in the EURUSD, rising as high as 1.08, after dipping to 1.05 overnight.

In any event, all eyes are now on Draghi and what the former Goldman banker reveals in three days.