Global Daily – Markets have not factored Recovery Fund risks

by: Floortje Merten , Tom Kinmonth , Bill Diviney

Euro Macro & Rates: European Recovery Fund likely to see significant changes – This Friday’s European Council meeting will be almost exclusively focused on the European Commission’s proposal for the Multiannual Financial Framework 2021-2027 and the European Recovery Fund. This meeting’s aim is not yet to reach an agreement, but instead to let Member States exchange views on the proposal, serving as a starting point for in-depth discussions between the Council’s President Charles Michel and EU-leaders over the coming weeks. We think a final agreement is still far away, as more and more Member States appear to have reservations about specific aspects of the EC’s plan.

Proportion grants versus loans and allocation key amongst main sticking points – Whereas the southern EU countries, backed by Germany, stress the importance of a resolute agreement on a Recovery Fund with a significant grant component, the Frugal Four, accompanied by Finland, will reiterate tomorrow that they want to see the grant component reduced, or even removed, as the Netherlands prefers. As well as the discussion about the proportion of grants versus loans, a discussion about the allocation key has also broken out. Whereas the EC’s allocation key is based on population, GDP per capita and the average unemployment rate from 2015 to 2020, reflecting a Member State’s capability to get out of the crisis, multiple EU-leaders argue that the distribution of funds should instead reflect the direct economic consequences of the Covid-19 outbreak, reflected by the subsequent decrease in real GDP, possibly complemented by the rise in unemployment.

Besides those two fundamental issues, the EC’s proposal entails more stumbling blocks. Multiple Member States criticize the creation of ‘new own resources’. Meanwhile, Poland announced it finds it unacceptable to use expanded revenues from the Emission Trading System to repay the EU’s borrowed funds, as desired by the EC, as it would be a big hit to Poland’s economy, which is heavily dependent on coal. Also, the bloc of eastern European countries objects to the skew of funds to the south, despite the eastern bloc being relatively less wealthy. Highlighting the different interests of Member States, these examples underline that the discussion on the shape of the MFF and the European Recovery Fund will be a lengthy one.

Allocation key based on Covid-19-related hit to real GDP dramatically changes dynamics – We expect the final Recovery Fund to look significantly different in terms of size and allocation. With the Frugal Four and Finland sticking to their standpoints, we continue to expect the Recovery Fund to be watered down, and to consist of a more even split between loans and grants. Moreover, with at least 12 Member States, amongst which the Netherlands, Denmark, Austria, but also Belgium, Ireland and Czech Republic, opposed to the allocation key in its current shape, we deem it highly likely that the final allocation key will look drastically different. For example, an allocation key based on the change in expected 2020 real GDP between the EC’s Autumn and Spring Economic Forecast, would turn Ireland and France from net contributors into net receivers, whereas Portugal would turn from a net receiver into a net payer. Also Italy and Poland would have their allocation significantly reduced.

We expect recent rally in spreads on the back of Recovery Fund proposals to be partly reversed – Spreads across the eurozone have tightened significantly in response to the Franco-German and EC proposals, with the strongest spread compression across the periphery. We judge that about half of this spread tightening across the eurozone will be reversed, as we expect the final Recovery Fund to be significantly watered down. Moreover, we expect there will be multiple disappointments in markets over the summer, as it may take at least several months to get closer to an agreement, resulting in increased spread volatility driven by the Recovery Fund discussion over the next months. With the short-end of peripheral bond markets supported by TLTRO carry trades (see below), this sets the scene for a steepening of peripheral curves. Finally, within this general trend, a changed allocation key could see the government bonds of Portugal and Italy being punished the most, while those of Ireland and France could see more resilience. (Floortje Merten)

Euro Financials: TLTRO smashes records – The ECB announced that eurozone banks took EUR 1.31 trillion in funding, under most recent round of the central bank’s support programme, the TLTRO. This adds EUR 549bn of extra liquidity to the eurozone banking sector.

The easing of TLTRO conditions for the latest round of funding – in combination with the existing higher market funding rates and increased corporate lending – has led to an enormous take up by eurozone banks. The results today are broadly in line with our expectations – which were at EUR 1.4trn.

To put the numbers into context, today’s take up is equivalent to a full periphery use of their TLTRO allowance (EUR 887bn minus current holdings), and roughly a 35% usage of TLTRO allowance (EUR 700bn) for non-periphery eurozone banks. As such, it is the involvement of the non-periphery banks in this round that has been the game changer in terms of uptake, when compared to previous TLTRO rounds. Non-periphery banks – which are usually not that active in the programme – have been lured by the new very generous conditions that are available. Meanwhile, the latest round of TLTRO is not simply being used as a funding source but as an excellent opportunity to enhance profitability. Banks in the core could park some funds in the deposit facility to pick-up a carry, while we could well see peripheral banks using some of the funds to invest in the short end of their sovereign curves. Indeed, banks in the periphery have continued to demand heavy amounts to make use of their recently increased allowance. The TLTRO 3.4 settlement is next week, on 24 June. (Tom Kinmonth)

BoE View: QE gets a boost, but more will probably be needed – The Bank of England raised the ceiling on asset purchases today by GBP100bn to GBP745bn, in line with our and consensus expectations. However, it also signaled a much slower pace of asset purchases than seen in the previous round of QE, with the BoE indicating that the additional GBP100bn would be completed “around the turn of the year.” In contrast, for the previous GBP200bn round announced in March, purchases were to be completed “as soon as operationally possible.” Gilt yields jumped 10bp following the announcement, before settling back around 6bp higher at time of writing.

Expectations for negative rates from the BoE also unwound, after Governor Bailey said that there had been no discussion on the topic. In the accompanying minutes, the MPC indicated that 2020 GDP would likely be less weak than had been projected in May, and indeed the BoE’s forecast for this year is exceptionally weak at -14% (our own forecast is -8.5%). However, its 2021 forecast remains much too optimistic at 15% (ABN: 5.2%), leaving output just 1.1pp below Q4 2019 levels; we expect GDP to be 3.2pp below Q4 19 levels. Indeed, alluding to the likelihood for greater long-term damage to the economy from the pandemic, the MPC acknowledged that the labour market had deteriorated by more than it expected in May, with the minutes noting that “the latest business and household surveys suggested upside risks to the path of unemployment.” We think the MPC will not be happy with the rise in yields following today’s announcement. Combined with downside risks to the outlook, we view today’s action as insufficient, and that it will hit its current cap on asset purchases rather sooner than it is currently indicating – probably by the September MPC meeting. Hinting that a quicker pace of purchases was possible, Bailey commented after the decision that the BoE would “keep flexibility on the path of QE.” A higher pace of purchases would set the stage for a further boost to QE later this year. (Bill Diviney)