ECB Preview: We expect the size of the PEPP to be increased by EUR 750bn – Against the background of a deepening recession, worsening inflation outlook and soaring bond supply, we expect the ECB to upscale its asset purchase programme and extend its duration into 2021. We also expect it to confirm that it will reinvest the proceeds of maturing securities purchased under the PEPP. We do not expect any other changes in monetary policy, though the Governing Council could emphasise flexibility in terms of deviations from the capital key for public sector securities.
Below we examine the main themes, policy options and likely market reaction.
Growth and inflation – ECB President Lagarde has already signalled that the central bank’s economists now see the economy developing somewhere in between their medium and severe scenarios published last month. That would point to a decline in GDP of around 10% this year (amazingly this was +0.8% in the March projection) and a 4.5% rebound next year. The ECB did not present any numbers for inflation under these scenarios, saying that the demand as well as supply nature of the shock made this uncertain. We think the ECB will almost certainly judge that the net effect of these factors points to lower inflation over the medium term. We expect the central bank staff to project headline inflation at around 1% in 2022 compared to 1.6% in March (we are more negative on the inflation outlook).
Asset purchases – We expect a EUR 750bn increase in the PEPP doubling the total size to EUR 1.5 trillion. This reflects the deep recession in the economy and the significant disinflation it will trigger over coming years. Indeed, the risks of a sustained period of modest deflation are now significant. Furthermore, we estimate additional corona-shock related government funding needs for this year of around EUR 1050bn. The PEPP is currently insufficient to mop up this supply (given that not all purchases are government bonds). Indeed, we think the ECB will need to absorb a lot of this additional supply to prevent a tightening of financial conditions. Given this, we also think that public sector purchases will have a very heavy weight in the programme. For the PEPP and additional APP envelope, we assume a distribution of around 80% to public sector assets, 17% to corporates and 3% to covered bonds (although the ECB will not publish anything on the distribution of future purchases).
Modalities of programmes – We think the ECB will extend the duration of the PEPP to 2021, possibly to end Q1, but most likely to end Q2. This reflects the likely slow recovery and ongoing downside risks to inflation. In our view, the Governing Council will also confirm for the first time that it will reinvest the proceeds of maturing securities purchased under the PEPP ‘for an extended period of time past the date when the Governing Council starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.’ This would be consistent with the current forward guidance on APP reinvestments. Given the short-dated securities (bills and CP) bought under the PEPP will soon start to mature, we do not think that the ECB can delay the guidance on PEPP reinvestments too much longer. Meanwhile, the ECB should signal that while the capital key will remain the allocation method for purchases of public sector securities, it has full flexibility to respond to market conditions.
Finally, we do not expect the ECB to expand the universe of corporate purchases to include recently fallen angels. Although it has changed its collateral framework in this fashion, we think that the balance sheet risks of outright purchases of high yield securities are different from those it takes in accepting lesser quality collateral in TLTRO and other refi operations (with the bank still responsible for paying back the loan).
Deposit rate – We do not expect a deposit rate cut at this meeting and judge that policy rates have very likely reached a trough. The case for a deposit rate cut has strengthened over recent weeks, due the rise in the spread between 3-month Euribor rates and the deposit rate, which has effectively tightened the monetary policy stance, all other things being equal. However, Euribor rates have started to come down, and the excess liquidity created by the asset purchase and TLTRO programmes should help the interbank curve to normalise. If that were not to be the case, then the ECB could reconsider in coming meetings. In any case, the ECB has clarified that it did not cut the deposit rate earlier this year because it did not want to add to worries about bank profitability. That rationale still stands.
Bank support – We do not expect the ECB to loosen the conditions on the TLTRO or make the tiering system more favourable at this meeting. The ECB already loosened the conditions for the TLTRO in April to give banks plenty of time to judge participation in the upcoming tranche. Meanwhile, concerns on the rise of Euribor rates (see above) may mean that the ECB refrains from increasing the multiplier to exclude more excess reserves from the charge of the deposit rate at this meeting. However, we do think that it will do so later in the year.
Market reaction – If the ECB were to increase the PEPP by EUR 750bn as we expect, we would expect Bund yields to fall, curves to flatten, country and credit spreads to tighten and swap spreads to widen. This in combination with language suggesting even more flexibility on the capital key would see even more momentum behind country spread tightening, though it could moderate the fall in Bund yields somewhat (and hence the flattening of the curve and widening of swap spreads). We think that a EUR 500bn increase in the PEPP is much closer to being priced in, so we would likely see the market reaction described above, but more modest moves. Finally, a step up in the PEPP, of say EUR 250bn, would lead to disappointment and would likely see the exact opposite of! the market reactions described above, all other things being equal. Finally, in line with our base case, financial markets are not pricing in any cuts at this week’s Governing Council meeting. On its own, a rate cut would tend to steepen the yield curve, but be a negative for bank credit overall. Conversely, any moves to loosen the conditions on the TLTRO or make the tiering system more favourable at this meeting (against our base case) would be a positive surprise for bank credit.