ECB December Preview - PEPP 'Bazooka'

On the one hand, there are rising infection numbers and renewed lockdowns.

This has tilted our outlook to the downside.

On the other hand, there’s positive news on the vaccine.

But we also see now that the fourth quarter is very likely to show a drop in GDP, even if the situation is not as severe as in the spring.

It seems likely that this weakening is going to stretch into the next year, and also that the inflation outlook may be subdued for some time.

That has to be decided by the Governing Council. It’s important to acknowledge that we have already achieved quite a lot.

Financing conditions are historically low.  

We should now focus on preserving these favourable financing conditions for as long as necessary in order to support the recovery, reduce the potential scarring effects and counter the negative impact of the pandemic on the inflation outlook.

Given the high degree of uncertainty we’re still facing in the economy and the already very favourable financing conditions, I think it is appropriate to focus on preserving these conditions rather than easing much further.

Duration is the crucial aspect. 

Markets, firms and households need to understand that we will be there for as long as necessary.

We do not feel obliged to do what the market expects from us. We are guided by our mandate.

There are a number of important parameters that we can change.

It’s not just the amount, it’s also the duration. 

And it’s about communication.

What’s clear is that since the beginning of the pandemic, the PEPP and the TLTROs have proven highly effective. Therefore, these are likely to be the main instruments for our recalibration.

If you think about our previous decision, it was taken at a time when there was no second wave yet. Now we’re experiencing a second wave in Europe and other parts of the world. This seems to suggest that, even with news of the vaccine creating a lot of hope, the pandemic will be more protracted.

I think this has to be reflected in our policy decisions. For the previous decision, we had assumed that the pandemic period would extend until June 2021. Now this may appear too optimistic.

In fact, we have to distinguish between the health crisis and the economic crisis. A fairly positive scenario could be that by the middle of next year we are seeing the start of widespread immunity and we’ve managed the health crisis. But the economic crisis will take longer than the health crisis. There will be economic ramifications even once the health crisis has been overcome. What matters for our monetary policy decisions are mostly the economic effects.

We have not defined any quantitative criterion for the length of the pandemic crisis phase. At this stage, it’s impossible to say when it will be over. Therefore, we’re taking a step-by-step approach. If we now come to the conclusion that June was too optimistic, then this would lead to a prolongation of the pandemic crisis phase, without necessarily linking that assessment explicitly to a quantitative criterion.

The balance sheets of firms are now more fragile than they were in the first wave and that may mean that the scarring effects may be more important.

It is more about the duration than the intensity of bond purchases

ECB President Lagarde has been emphasising the importance of the duration of the ECB’s measures lately, while she has already said earlier that the pace of the PEPP purchases does not need to be at the same level as in the early stages of the pandemic.

Executive Board member Schnabel added that the ECB needs to debate the intensity of its asset purchases, clarifying that the ECB only needs to be buying bonds at a pace that will keep bond yields close to current levels instead of pushing them further down.

Her comments suggest that the ECB does not see a big need to push yields much lower from the current levels.

Such behaviour has also been illustrated in the latest PEPP purchase volumes.

The weekly pace rose to around 20bn in November in response to a small spike in yields, but fell back to around EUR 15bn again last week, as yields have fallen back.

Such numbers are considerably lower than the around EUR 30bn figures that were seen many times in the early stages of the pandemic.

We do not expect any commitment to a specific pace of purchases at the December meeting, even as the overall programme size is increased. 

Instead, the ECB will be more reactive in its purchases, with the main aim to prevent abrupt upward moves in bond yields and spreads rather than a goal of pushing yields further down.

Some could see this as a form of implicit yield curve control, even if the ECB is not going to announce any explicit yield targets.

Nevertheless, the ECB’s past behaviour suggests the central bank is not always quick to adjust its purchases in response to market moves, so quick short-lived upward moves in yields and spreads should not be excluded.

The ECB will also adjust its purchases based on bond supply. The pace of buying will be low in December when there will not be much issuance, but should pick up again in January, as also issuance picks up.

It is worth noting that a PEPP expansion of EUR 500bn should easily be enough to facilitate the ECB buying a similar share of net EUR government bond issuance in 2021 compared to this year.

As the ECB itself has pointed out, more monetary easing alone is not hugely effective in the current environment, but its bigger impact comes from empowering fiscal policy by keeping government borrowing costs low.

As TLTRO is tailored to support favourable lending conditions, we expect the ECB to be relatively aggressive in its easing of the terms.

Last week, ECB’s chief economist Lane said that all parameters could be tweaked. Of those parameters, we expect (1) a prolongation of the TLTRO discount to last for the entirety of the operation’s lifetime (from current June 2021), (2) no increase in the discount size from -50bp, (3) additional four operations with last allotment in March 2022 and (4) an increase in the eligibility pool.

The last point is the result of notably banks in the periphery countries having utilised close to their maximum allowance.

We expect the eligible TLTRO allotment to be increased to 70% (from 50%), which would allow around EUR1trn additional funding to be taken (at most), but this is significantly lower than the actual takeup would be.

We expect the tiering multiplier to be increased to 10x the reserve requirement (from 6), as excess liquidity has increased markedly as a result of the ECB’s bond buying and liquidity operations and is also set to increase at least through 2021.

An increase in the tiering multiplier should be seen in light of mitigating some of the negative side effects of banks’ profitability.

We continue to expect the PEPP to focus on public bonds, leaving private sector bonds to the APP.

There has been some discussion in markets as the whether the ECB could include fallen angels (bonds that have lost their investment grade rating) as part of its bond buying.

As of now, the ECB’s corporate bond holding database only shows 11 names as non-investment grade, which means that they would classify as a fallen angels.

The most noticeable are Renault, Lufthansa and Telecom Italia.

As this is a very specific issue, and a small subsection of the bond market, we do not expect fallen angels to be included.

If they are included, the market reaction would be found in name specific papers rather than general easing.

The ECB’s APP is currently running at EUR20bn/ month plus the additional envelope of EUR120bn until year end 

We do not expect an additional envelope to be announced as the PEPP is more flexible and important than the APP envelope.

The ECB may opt to increase the monthly APP purchase to EUR30-40bn, in a sign that it will commit a certain purchase rate. That said, this is less important than the PEPP near term, but an increase in the APP will be a sign of a very prolonged period of bond buying.

With the increase in the outstanding bonds in response to the COVID-19, the discussion about restriction of ISIN limits is not as relevant as in March.

If ECB increases the APP to above EUR40bn, it would have a market impact in our view.

There has been market speculation about transferring the flexibility of the PEPP to the APP. We do not expect this to be transferred as the ECB is clearly differentiating between what is a crisis response tool and what is a ‘normal’ instrument.

Yes, most likely. Staff projections for real GDP growth and HICP inflation will be driven by conflicting forces including new restrictions weighing on Q4 activity, a stronger EUR, a potential delay in fiscal support, but also vaccine hopes and a relatively stronger outlook for the world economy (and, of course, the always imminent outcome of Brexit negotiations).

That said, the starting point for next year will be much lower, due to carryover effects from weak Q4 GDP and low inflation, that will very likely result in a

downgrade to 2021 projections.

The ECB may try and balance out the pessimism with a slightly more upbeat growth outlook for 2022 and 2023 (with the latter being published for the first time), but they should also avoid any sense of complacency as long as inflation is showing no sign whatsoever of a sustained rebound.

 Our ECB preview: more of the same for (much) longer. https://t.co/nNcrg9O9wi pic.twitter.com/rhj9MDtEtI— Frederik Ducrozet (@fwred) December 4, 2020