ECB QE: Buxl/Bund tapering and step up in Ita/Fra/Spa Pernille Bomholdt Henneberg Anders Møller Lumholtz Senior Analyst, Euro Area Macro Research Chief Analyst, Fixed Income Research +45 45 13 20 21/+44 20 7410 8157 +45 45 14 69 98 perni@danskebank.com andjrg@danskebank.dk 7 September 2016 Investment Research www.danskemarketsequities.com Important disclosures and certifications are contained from page 18 of this report.
ECB QE: Buxl/Bund tapering and step up in Ita/Fra/Spa We expect the ECB to keep its powder dry at the meeting tomorrow, as economic sentiment has been very resilient to the Brexit vote. The patient stance is further backed by the fact that inflation is set to rise sharply later this year; however, mainly driven by the oil price. That said, the ECB s main concerns are the lack of an upward trend in the underlying price pressure and the persistently low market-based inflation expectations. In our view, this will eventually trigger an extension of the QE purchases, to be announced either in October or at the December meeting. See ECB Preview: Still awaiting more information, 24 August 2016. QE extension implies that the ECB will be confined by its technical restrictions, making it difficult to proceed with purchases in all sovereigns - including Germany in early 2017. Our main scenario is that the ECB will do nothing' (no change in restrictions) in September or in Q4, despite the increased focus on the German bond scarcity. No change in the restrictions would involve less buying of the long end of Germany and a shift in purchases from DE/FI/PT/IE to countries with no binding restrictions. Hence, a de facto deviation from the capital key in DE/FI/PT/IE, causing 'tapering' in these countries while increasing purchases in the other countries. In this do nothing scenario, IT/FR/ES would tighten massively versus Germany, the German curve steepen and Buxl/Bund ASWs would tighten. Other possible ECB actions related to the QE restrictions would impact the EUR FI market differently. Buying below the deposit limit or lifting the issue/issuer limit would have significant implications for the EUR FI market curves and spreads. Switching from a capital key to an outstanding debt key would trigger a large repricing across sovereigns. 1
ECB QE: Buxl/Bund tapering and step up in Ita/Fra/Spa At tomorrow s meeting, other possible scenarios include the ECB creating a 'task force, which would look at relaxing current restrictions and announcing the change in Q4. The final announcement in Q4 is likely to involve flexibility on all current restrictions including the deposit restriction, the issue/issuer limit and possibly even deviations from the capital key. In addition, a black box' solution is possible, which would allow 'full flexibility' (release information afterwards). Current rules and restrictions could be used as a guidance but full flexibility could be allowed including the possibility to break all current restrictions, i.e. (1) the deposit rate restriction; (2) the issue/issuer limit; and (3) even deviate from the capital key. Despite the significant impact on the FI market, a changed purchase pattern will not change the ECB s inflation outlook. It is just a step on the way and would buy the ECB more time before other assets (Senior Financials, equity ETFs) could be included in 2017. Market pricing. During the past month, the German curve has steepened with the 2Y yield decreasing to -68bp. Buxl ASW has tightened around 15bp since Brexit. The price action suggests that the market is pricing in some probability of abandoning the deposit restriction and an outcome that implies less buying of the long end of Germany. Price action in cross sovereign spreads has been more muted, indicating a low market probability of a de facto deviation from the capital key. There is no clear consensus on the most likely outcome nor the timing of the announcement. It is our impression that the majority expects the ECB to introduce some flexibility in the QE purchases, including possibly combining some of the above options. 2
Sharp rise in inflation unlikely to prevent a later QE extension as the increase in inflation is driven mainly by the higher oil price Inflation set to rise sharply in coming months 2.00% Higher inflation is driven by the oil price 1.50% 1.00% Inflation market pricing is still significantly below our forecast 0.50% 0.00% Sep-16 0.45% Jul-17 0.60% The medium-term part of the curve is priced almost flat -0.50% -1.00% Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19 Dec-20 HICP inflation Danske forecast Market pricing ECB Jun projection Source: Bloomberg, ECB, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets 3
ECB concerned about the lack of upward trend in core inflation while low inflation expectations should also remain in focus ECB is concerned about low core inflation Will inflation ever reach the 2% target? Source: ECB, Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets 4
Change in QE (PSPP) purchase pattern
PSPP buying restrictions already affecting purchases in Por/Ire QE restrictions (issue/issuer cap) already causing reduced purchases (lower than capital key) in Portugal and Ireland. PSPP fraction remain very high PSPP increase more subdued in IE /PT 90 80 EUR bn 85 85 85 81 % 95 45% Apr-Aug purchases vs Q12016 average, % 40% 70 60 50 61 60 63 63 61 52 62 64 63 50 62 62 61 60 90 85 35% 30% 25% 40 20% 30 80 15% 20 10% 10 75 5% 0 0% -10 70-5% PSPP CBPP3 ABSPP CSPP PSPP share (rhs) Source: ECB, Danske Bank Markets Source: ECB, Danske Bank Markets 6
ECB QE running out of bonds/bunds/buxl? The deposit buying restriction (-40bp) has increased the average maturity in PSPP purchases in Germany from below 6Y in May-15 to 11Y Aug-16 ECB pushed further out on the curve Significant PSPP holdings already 15 14 13 12 11 10 9 8 7 6 5 Marginal maturity (years) DE FI NL AT FR BE IE ES IT PT All Mar-15 May-15 Dec-15 Mar-16 Aug-16 10.2 250 200 150 100 50 0 EUR bn 237.9 188.9 164.4 131.4 117.9 53.1 32.7 26.0 20.8 16.7 14.9 DE FR IT ES NL BE AT PT FI IE Others Purchases end of Aug-16 Source (all): ECB, Danske Bank Markets We estimate that PSPP holdings of Germany 8Y-31Y will be approaching and maybe even hitting the 33% issue cap (isin) around Q1 17. Note, also non-monetary policy holdings are included in the issue cap. 7
ECB options what is most likely? ECB's options Market implications Slowdown in DE/FI/IE/PT and step-up in rest 30% Purchases in Portugal, Ireland, Finland and Germany will be reduced as they hit the 33% issue/issuer limit. The (a) 'Do nothing' (no change remaining countries will benefit from higher purchases in restrictions) - slowdown in that will be distributed using the capital key (ECB still purchases in buys EUR80bn per month). Hence, it is a 'de facto' Ger/Fin/Por/Ire due to deviation from the capital key in countries where issue/issuer caps being restrictions are causing 'tapering' while increases in other replaced with a step-up in countries will be distributed with the capital key. Ita/Fra/Spa etc. (according Italy/France and Spain will tighten significantly versus to the capital key) Germany. The German curve will steepen and Buxl/Bund ASW tighten. (b) Create a 'task force' that will look at relaxing current restrictions and announce change in Q4 (c) 'Black box' solution - 'full flexibility' (release information afterwards) (d) Keeping the current QE restrictions and include other assets Market talk on possible scenarios and market impact will intensify. The final decision is likely to involve flexibility on all of the current restrictions including the depo restriction, the issue/issuer limit and possibly even deviations from the capital key. Every comment from the ECB will be scrutinised for information. Market moves are likely to be less violent although some further Buxl ASW tigtning as long-end buying in Germany is likely to be reduced. Allow full flexibility and the possibility to break all current restriction, i.e. (1) the deposit rate restriction; (2) the issue/issuer limit; (3) even deviate from the capital key. We think that QE purchases in this scenario would be reduced in the long end of Germany. Hence, Buxl/Bund- ASW will tighten and also Ita/Spa/Fra are likely to tighten versus Germany due to the 'de facto' abandoning of the Capital Key. ECB has previously included new assets to the QE universe and continuing along these lines will have a smaller impact on FI markets but be more supportive for the outlook for inflation. 26.4% 25.8% 25% 22.4% 20.8% 20% 18.0% 16.1% 15% 13.2% 13.0% 10% 7.3% 5.9% 4.5% 5% 4.1% 3.6% 3.6% 2.9% 3.3% 2.6% 1.8% 1.3% 1.7% 0.9% 0.9% 0.0% 0.0% 0% Buying according to ECB capital key Capital key after 50% DE/FI/PT/IE reduction Source: ECB, Danske Bank Markets 8
(a) The ECB does nothing - de facto deviating the Capital Key A de facto deviation from the Capital Key The ECB recently concluded that implementation of the asset purchase programme had proceeded smoothly, notwithstanding market reports of emerging scarcity in some market segments. Hence, the ECB could continue without changing the QE restrictions but this would soon affect the purchase pattern. An issue/issuer-related slowdown in some countries (DE/FI/IE/PT) would mean an increase in other countries according to the capital key (IT/FR/ES) as the ECB would maintain the monthly purchases of EUR80bn. Deposits currently going mainly to core 35% 30% 25% 20% 15% 10% 5% 0% 30% 7% 15% 6% 5% 26% 3% Source: ECB, Danske Bank Markets 1% 2% 2% 0% 0% 1% 0% 0% 0% 1% 0% 0% DE FI NL LU AT FR BE IE ES IT PT GR CY EE LV LT MT SK SI Core 54% Deposits at national central bank in % of total Eurosystem deposits Semi-core 33% Periphery 6% Others 7% One possibility is that the ECB will create a task force to look at the issue and wait for a market consensus to be formed. 9
(b) The ECB keeps the restrictions but includes other assets to QE Not higher inflation by changing restrictions. Despite the significant impact on EUR FI markets, changing the QE restrictions would have a limited impact on the outlook for inflation, which is the most important for the ECB. The ECB previously expanded QE universe Including other assets such as senior financials or ETFs would have a much bigger impact on the economic outlook but this option would probably be more difficult for some Governing Council members to accept. However, the ECB previously expanded the QE universe to include new assets and the it does accept senior financials as collateral. Source: ECB, Danske Bank Markets 10
Several possible changes to QE restrictions and the market impact QE (PSPP) change Pros Cons Market implications (1) Removing the no buying below the -40bp deposit limit Would imply a large amount of bonds could be included in the PSPP. On the German curve, bonds out to 8Y are trading with a yield below -40bp (more than 60% of the German curve). Also, a substantial part of the other core market, supras and agencies is excluded due to this limitation. This restriction could result in losses for the Eurosystem as the ECB's effective 'funding cost' is the deposit rate at currently -40bp. Would push yields in the short end of core lower and cause substantial curve steepening as purchases in longer maturities decrease. Similarly, in ASW it would cause Bund and BUXL ASW tightening while 2Y is likely to widen. (2) Shifting from 'capital key' to an 'outstanding debt key' Would mean that the QE programme could proceed for longer with current buying restrictions as purchases would be biased towards sovereigns with higher debt levels. The fact that countries with a higher debt level would be rewarded with higher purchases is likely to be criticised by some Governing Council members. Would benefit Italy, France, Belgium and Austria at the expense of Germany, the Netherlands, Finland, Ireland and Portugal. Purchases in Spain would be around the current level. In ASW, it is likely to cause Bund ASW tightening - particularly in the 30Y, which has been most squeezed. Core curves are also likely to steepen on this. (3) Removing the 33% issue/issuer limit Would allow the QE programme to be extended further without hitting the issue/issuer limits. These restrictions were put in place to prevent the ECB from actively having to take a stance in the case of a new EGB haircut as was the case with, for instance, the Greek PSI. A 'low' holding would mean that the ECB could be CAC'ed into taking the same losses as other investors in a scenario with an orderly default; thereby not having to freely accept 'monetary financing' of euro area governments. Purchases in Portugal and to some extent also Ireland have already been reduced due to (most likely) these concerns. Hence, these would be the main beneficiaries. In the core, Germany/Finland could also benefit further from this. Bund and Buxl spreads could also widen further on this and the core curve flatten further in, for instance, the 5-30Y. (4) Removing maturity restrictions (sub 2Y and plus 31Y) (5) Removing the isin limit on non-cac bonds Would free some but very limited additional liquidity. Would allow higher purchases in 'off the runs' and thereby increase the eligible basket. The additional market liquidity in +31Y is very limited. Is likely to create 'kinky' points on EUR sovereign curves. Would cause performance in the ultra long segment across issues and also versus swaps. Off-the run non-cacs would outperform CACs bonds resulting in curves with kinks. Source: Danske Bank Markets 11
(1) Removing the limit of not buying below the -40bp deposit rate Pros. A large amount of bonds in core markets, supras and agencies would again be included in the PSPP. The German curve out to 8Y is trading with a yield below - 40bp (more than 60% of the curve). Cons. The Eurosystem could end up with losses as the ECB s effective funding cost is the deposit rate currently at -40bp. Markets. Lower short-end core yields causing a substantial curve steepening as purchases in longer maturities decrease. In ASW, it would cause Bund and Buxl ASW tightening while the 2Y is likely to widen. Of the German curve, 62% is below -40bp 1.40% 1.10% 0.80% 0.50% 0.20% -0.10% -0.40% Yield Years -0.70% 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 Source: ECB, Danske Bank Markets 43 German bonds (+62% of MV) not eligible for PSPP (31 was excluded on 17 Apr yielding below -20bp) Germany government bonds (live) 17/04/2015 ECB deposit rate 12
(2) Shifting from capital key to outstanding debt key Pros. The QE programme could proceed for longer with an outstanding debt key, as purchases would be biased towards sovereigns with higher outstanding debt levels without violating other restraints. Cons. Countries with a high debt level would be rewarded with higher purchases, which is very likely to be criticised by some Governing Council members. Markets. Italy and France would benefit mainly at the expense of Germany. Spain would be unaffected (see chart to the right). In ASW, it would cause Bund ASW tightening, particularly in the 30Y, which has been the most squeezed. The German curve is likely to steepen on a bit on this. FR/IT to benefit most at the expense of DE 30% 26.4% 25% 24.3% 25.3% 20.8% 20% 18.0% 18.0% 15% 13.0% 12.3% 10% 5.9% 5.2% 5.5% 5% 3.6% 2.9% 3.4% 2.6% 3.3% 1.6% 1.8% 1.3% 1.7% 1.6% 1.5% 0.0% 0% Buying according to ECB capital key Buying according to outstanding debt Source (both charts): ECB, Macrobond, Bloomberg, Danske Bank Markets 13
(3) Removing (increasing) the 33% issue/issuer limit Pros. The QE programme could be extended beyond March 2017 without hitting the purchase restrictions. Cons. The ECB would have to actively take a stance in the case of a EGB haircut as, for example, the Greek PSI. A low holding would mean that the ECB could be CAC ed in to taking the same losses as other investors in a scenario with an orderly default and thereby not freely accepting monetary financing. Big dispersion in monthly purchases recently Monthly PSPP purchases - index 2015 average 180 160 140 120 100 80 60 Markets. Purchases in Portugal and to some extent Ireland have already been reduced due to the issue/issuer restriction. Hence, they would benefit the most, with Germany and Finland. The Bund and Buxl spread would widen and the core curve flatten (5-30Y). Source: ECB, Danske Bank Markets Total Supra FR FI DE NE IE IT PT ES 14
(4) Removing the sub 2Y and plus 31Y maturity restrictions Pros. Some but very limited additional bonds could be purchased. Cons. The market liquidity in the +31Y is very limited. Markets. This would trigger performance in the ultra long segment of the curve across sovereigns and also versus swaps. Only 1% of outstanding debt is above 32Y EUR bn 0-2y 2-5y 5-10y 10-15y 15-20y 20-32y 32y+ Total Germany 294 300 311 119 36 182 0 1,242 Finland 11 32 35 10 0 7 0 95 Netherlands 82 86 104 22 17 70 0 381 Austria 43 52 89 21 8 34 7 254 France 232 408 501 157 111 131 56 1,597 Belgium 72 51 140 40 57 55 4 419 Ireland 7 50 45 10 0 7 0 119 Spain 168 237 276 78 31 102 5 897 Italy 306 390 463 207 84 167 0 1,616 Portugal 21 36 48 5 0 13 0 122 Other 17 44 31 9 8 1 0 110 1,252 1,685 2,043 677 354 768 72 6,852 % of outstanding 0-2y 2-5y 5-10y 10-15y 15-20y 20-32y 32y+ Total Germany 24% 24% 25% 10% 3% 15% 0% 18% Finland 12% 33% 37% 11% 0% 7% 0% 1% Netherlands 22% 22% 27% 6% 4% 18% 0% 6% Austria 17% 20% 35% 8% 3% 14% 3% 4% France 15% 26% 31% 10% 7% 8% 4% 23% Belgium 17% 12% 33% 10% 13% 13% 1% 6% Ireland 6% 43% 38% 8% 0% 6% 0% 2% Spain 19% 26% 31% 9% 4% 11% 1% 13% Italy 19% 24% 29% 13% 5% 10% 0% 24% Portugal 17% 29% 39% 4% 0% 10% 0% 2% Other 15% 40% 29% 8% 7% 1% 0% 2% 18% 25% 30% 10% 5% 11% 1% 100% Source (both charts): Danske Bank Markets 15
(5) Removing the issue limit on non-cac bonds Pros. Higher purchases in off the runs and thereby increasing the eligible basket of assets. Cons. This is likely to create kinky points on EUR sovereign curves. Markets. Off-the-run non-cac bonds would outperform CAC bonds, resulting in curves with kinks. CAC vs non-cac across countries % CAC of outstanding in maturity bracket 0-2y 2-5y 5-10y 10-15y 15-20y 20-32y Germany 46% 41% 69% 8% 0% 18% Finland 0% 36% 64% 36% #N/A 0% Netherlands 32% 37% 66% 0% 0% 26% Austria 0% 29% 38% 37% 100% 7% France 21% 35% 40% 37% 9% 24% Belgium 17% 0% 48% 22% 15% 47% Ireland 0% 0% 63% 100% #N/A 100% Spain 33% 49% 64% 60% 0% 29% Italy 50% 39% 51% 29% 30% 33% Portugal 0% 0% 80% 100% #N/A 26% Total 36% 37% 54% 32% 18% 27% Source: Danske Bank Markets 16
Market impact: most scenarios have Bund/Buxl ASW tightening and curve steepening (if QE extension is priced in) Bund and Buxl squeeze SHTZ, BOBL, BUND and BUXL ASW 6M, bp Long-end ASW likely to come lower in most scenarios German ASW 6M curve, bp 50 45 40 35 30 25 20 15 10 5 0 SHTZ ASW 6m BOBL ASW 6m BUND ASW 6m BUXL ASW 6m Current curve (07-Sep-16) Curve (01-Apr-16) Curve (01-Sep-14) Curve (27-Jun-16) Curve (09-Mar-15) Source (both charts): Bloomberg, Macrobond Financial, Danske Bank Markets 17
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