Euro Rates: Italian yield surge makes early ECB announcement a distinct possibility – Italian government bond yields continued their upward trend yesterday, moving through levels that had already triggered ECB Executive Board anxiety about ‘fragmentation’. At the time of writing, the Italian 10y yield had risen by around 20bp to 2.15%, while spreads had jumped by 25bp to 260bp. As noted earlier, we see ECB intervention levels of around 2% for the yield and 250bp for the spread. Indeed, last week’s uptrend in Italian bond yields already looks to have triggered phase one intervention from the ECB, in the shape of speeches from the Executive Board, which signalled its preparation to increase the size of its asset purchase programmes (see here), as well as likely a step up in the pace of its Italian bond buys. However, yesterday’s market action tells as that phase one intervention has failed.
The ECB will likely need to move decisively and move to phase two. The next step is for the ECB to follow up on its verbal intervention by announcing a step up in the PEPP to contain fragmentation risks. Investors are concerned by the deterioration in the outlook for Italy’s government debt (see here) against the background of sharply falling nominal GDP growth and the government’s fiscal package to fight the crisis. In the near term, this also points to a sharp increase in bond supply, Meanwhile, there are worries that Italy’s sovereign rating may well eventually be downgraded to below investment-grade levels by one or more rating agencies.
The combination of more supply coming to the market and investor flight may mean the ECB lacks the firepower to cap yields and spreads. Or alternatively, it might be that investors are not convinced that the ECB has the firepower and this is making its interventions less effective. On the eurozone aggregate level, we estimate additional government funding needs of around EUR 700bn. Yet sovereign purchases under the announced APP envelope and PEPP will likely amount to EUR 500bn. The PEPP is not large enough. By comparison, the Fed has bought USD 1.3 trillion in Treasuries alone since the start of March, and looks on track to purchase an amount equivalent to the US government’s additional funding needs (USD 1.8 trillion) within the next few weeks.
There are also strong macroeconomic arguments to step up the PEPP. Financial conditions have tightened significantly over the last few weeks. The initial PEPP announcement has been only modestly successful in arresting this tightening. Meanwhile, the shock to the economy looks set to drive core inflation much lower and has raised the risk of deflation.
We stick to our call of a EUR 500bn increase in the PEPP taking the total programme size to EUR 1.25 trillion. We think this will happen sometime this month. With the Governing Council scheduled for next week and the EU leaders call this week, the ECB may well chose to wait to the official meeting. However, recent developments in the Italian bond market have made an another emergency ECB announcement a distinct possibility. (Nick Kounis)
Euro Macro: Jump in Germany’s ZEW expectations reflects current misery – Germany’s ZEW expectations indicator jumped higher in April, rising to +28.2, up from -49.5 in March. The indicator, which measures the expectations of economist and market analysts about the economic conditions during the next six months (balance of ‘improve’ minus ‘get worse’) normally tends to track turning points in Germany’s business cycle relatively well. However, this time the improvement merely reflects a dramatic deterioration in the part of the survey that measures current conditions, which staged its sharpest monthly drop since the start of the series in January 1992 (so also sharper than in any month during the global financial crisis). The current conditions indicators (‘good’ minus ‘bad’) dropped to -91.5 in April, down from -43.1 in March, which implies that the series is almost at its lowest possible point of -100. Indeed the historical pattern in the two parts of the ZEW survey shows that at very low levels of current conditions, the expectations indicator always improves. Indeed, according to the written statement of the ZEW institute some special questions on the coronavirus had been asked in the April survey, and the answers to these questions showed that the experts did not expect to see positive economic growth until the third quarter of 2020. Moreover, “economic output was not expected to return to pre-corona levels before 2022”, according to the statement. This view is in line with our own scenario for the German economy and the eurozone as a whole. Indeed, we expect two sharp contractions in quarterly GDP in 2020 Q1 and Q2 and a technical rebound in Q3. However, after that, we expect growth to slow down again significantly to levels somewhat below zero due the second round effects stemming from rising unemployment, corporate bankruptcies and tightened financial conditions. Only in the second half of 2021, a robust and sustainable recovery in growth is expected. Therefore, Germany’s GDP should be still below the level of 2019Q4 at the end of 2021. (Aline Schuiling)