ECB Stand And Deliver?

Probability weighted For Large Scale Purchase Programme

On 22nd January, markets expect the ECB to announce a large-scale asset purchase programme, including sovereign bonds, in response to increased deflation risks and the de-anchoring of inflation expectations. In addition to sovereign bonds, the market expects the ECB to broaden its existing ABS and covered bond asset purchases to include corporate bonds and agencies.

Most market participants seem to expect a sovereign QE package of EUR 500bn but the markets doubts that this would be good enough. It would have a chance of boosting the ECB balance sheet by EUR 1trillion only if it were complemented by aggressive purchases of corporate debt and supranational debt.

Capital keys

The market remains of the view that the ECB will communicate a monthly flow of public and private sector asset purchases of around €40bn per month, for as long as necessary dependant on the inflation outlook. Sovereign bond purchases will likely be circa €25bn per month, markets expect the ECB to conduct purchases of sovereign government bonds according to the proportions of the ECB capital key, itself weighted according to population and GDP.

The Mechanism

Markets believe that there are broadly two ways that the ECB could deploy a sovereign bond purchase programme: via regular reverse auctions (e.g. like Fed and BoE5) or conducting purchases via national central banks and the ECB. Based on previous examples, such as the SMP programmes and the current Covered Bond/ABS purchase programmes, markets think the latter method is more likely. In terms of market impact, the first option would depress government bond yields for a slightly longer period than the second as the size and frequency of purchases are likely to be more transparent.

Markets expect sovereign purchases to be confined to conventional bonds denominated in EUR and issued by euro area member states. Markets dont expect any purchases of floating rate notes (e.g. CCT) or bills, at this stage. The base case is for no purchases of inflation-linked bonds as the ECB might be concerned about distorting a market-based measure of inflation expectations. But as one could also argue that not buying would also
distort the market, this is a weak base case and it may be that the ECB does not rule out buying linkers whether it ends up doing so or not.

Greek and Cypriot Considerations

To limit credit exposure, markets expect the ECB to apply a minimum first best credit assessment of at least investment grade. The absence of market access and the potential legal risks this could entail are likely to sway the ECB towards excluding GGBs and Cypriot government bonds. Markets therefore continue to expect the ECB initially to either exclude Greece and Cyprus outright or technically include them under conditions so severe that would amount to a de facto exclusion for the foreseeable future.

Euro Reaction

The dominant sentiment in FX markets seems to be scepticism and many seem to expect the ECB to underwhelm. However, as discussed above, the market may underestimate Mr. Draghi’s determination. The ECB is well aware of the risks associated with disappointing markets on QE and will try hard to surprise to the upside.

• Bearish – A bolder than expected move by the ECB would be EUR negative initially. Depending on how powerful the communication is, the downside for the EUR could quite easily be towards 1.10 against the USD.
• If the balance sheet expansion required to bring inflation closer to the ECB’s target was judged to be EUR 1trillion in September, you could argue that it would need to be bigger now (with 5y5y inflation expectations having dropped to 1.5% and headline inflation numbers even in the negative now).
• This argument may have been weakened by the fact that the ECB has recently tweaked market expectations down, so that the EUR 1trillion number markets are looking for would already be a positive surprise.
• Bullish – Mr. Draghi has carefully steered the discussion on the effectiveness of sovereign bond purchases towards the effect on portfolio rebalancing and the exchange rate. A stronger than expected announcement on 22 January could push the EUR further towards 1.10 initially.
• However, a significant and credible QE programme may well be seen as improving the outlook for the eurozone in the longer term, resulting in supportive currency flows.