Following the recent aggressive policy measures by the US Federal Reserve, the European Central Bank on Wednesday announced plans to buy an additional EUR 750 billion in bonds.
The Pandemic Emergency Purchase Programme will cover both sovereign bonds and corporate debt. The programme will last until the crisis is considered to be over.
The ECB reiterated that it will do everything necessary within its mandate. The central bank is prepared to explore all options and all contingencies to support the economy through this shock.
ECB determined to tackle liquidity issues, economic damage
Markets had expected that the ECB would support fiscal expansion by buying more assets. In our view, this package of measures demonstrates the ECB’s determination to address the key issues for economic policymakers. Namely, the threat of a liquidity crisis in the economy, and supporting government financing of spending measures to sustain the economy.
In addition to the new measures, the ECB can now signal that existing issue limits on bond purchases are not a binding constraint, and commit to controlling sovereign bond yields in general.
In our view, the measures announced by the ECB on 12 March were well-calibrated – providing very cheap funding to banks to support lending and providing capital relief to banks. Since then however, a number of eurozone countries have imposed more severe lockdowns as the coronavirus continues to spread and affect wide segments of society and broad sectors of the economy.
ECB President Christine Lagarde estimated this week that lockdown of a month would reduce eurozone growth by 2% relative to the 0.8% the ECB had forecast for this year. If the lockdown were to last three months, the ECB estimates it would knock growth by more than 5 % this year.
ECB support can be expanded further
The programme announced on Wednesday has no upper limit on purchases. It can be scaled up and adjusted by as much as necessary and for as long as needed.
At the same time, the ECB has expanded the range of assets eligible for purchase to commercial paper by non-financial issuers and eased its collateral standards to allow banks to raise money.
The ECB also paved the way to buying Greek sovereign debt for the first time since the eurozone sovereign debt crisis by announcing a waiver for its debt under this new asset-purchase programme.
Limits remain an issue
The ECB is suggesting some flexibility on its commitment to buy sovereign bonds in proportion to the relative size of each country’s economy and its contribution to ECB capital — known as the capital key.
It appears, however, that the ECB’s self-imposed limit to buy no more than a third of any government’s eligible debt remains in place. The ECB is close to hitting this limit for some countries, such as Germany and the Netherlands.
This 33% limit has been the object of much discussion. It was designed to avoid any risk of the ECB being considered to be directly financing governments via ‘monetary financing’.
There is a school of thought that argues that if the ECB owns more than a third of a country’s debt, it would theoretically have a blocking minority in any future debt restructuring negotiations, which would force it to vote. A vote backing a debt restructuring in favour of a member state, reducing its overall debt, could be construed to be monetary financing. Others consider there is no sound legal basis for this argument.
For the moment, the 33% limit remains in place. It may well be that this limit is hit at some point in the coming weeks and will come up for another review.
Scope now for a decisive fiscal response
On 16 March, eurozone finance ministers pledged an ‘unlimited commitment’ to contain the economic damage and restore confidence. European Union fiscal rules are effectively being suspended. This muscular fiscal response will mean there will be more bond issuance available for the ECB to purchase.
It seems inevitable that a major part of the costs arising from the virus pandemic will be covered by government debt. This ECB package looks to be part of this process in creating room for a decisive fiscal response in the eurozone.
As we have pointed out in previous posts, the combination of a simultaneous supply/demand shock resulting from the coronavirus epidemic followed by a crash in the oil price represents a major deflationary shock to the global economy.
The ECB is doing all it can to support governments in limiting the risks to the real economy via a credit crunch. There is an ongoing surge in demand for liquidity. By expanding its balance sheet, the ECB is helping to meet the demand generated by companies and people seeking cash in what is a period of considerable uncertainty.
To quote ECB President Lagarde on Thursday morning:
Extraordinary times require extraordinary action. There are no limits to our commitment to the euro. We are determined to use the full potential of our tools, within our mandate.
We believe the ECB announcement has clearly taken the pressure off the fixed income market. After an unfortunate press conference last week, ECB President Lagarde is back in the saddle and has shown that she can make good on Mario Draghi’s legacy.
Last week, the ECB gave itself more capacity to buy bonds issued by eurozone countries by increasing its existing EUR 20 billion-per-month programme of asset purchases by an extra EUR 120 billion over the course of this year. It also reinforced the range of cheap loans it offers to banks and granted lenders various forms of capital relief.
The intitial reaction to this new ECB package in bond markets was positive, but after the volatility of recent days, markets remain cautious.
Among sovereign eurozone bonds, Italian bonds were the best performers on Thursday with yields falling by about 70bp on all maturities. Yields of Spanish and Portugese sovereign debt fell by around 40bp.
The ECB is already buying Italian sovereign debt. It had started making purchases a few days ago and is likely to step up the pace now.
The ECB should provide liquidity to investors in need of cash.
While this package will not necessarily immediately stop the selling, it will certainly reassure markets about the availability of cash.
As far as eurozone corporate debt is concerned, liquidity is improving in some sectors. It remains poor to non-existant in very short maturities (money market).
We have seen little buying interest for corporate debt. There were few bids over the last few days, although reassuringly, Thursday saw more.
Over the last few days, we increased the liquidity of our funds, particularly the short-duration funds by selling holdings of sovereign debt or corporate investment-grade bonds. We are now comfortable with the levels of cash we hold.
We have been actively managing our interest rate risk. We reduced interest rate risk before yields rose over the last few days and anticipated longer-dated German bond yields rising faster than their shorter-term peers.
However, the outperformance these strategies have generated does not compensate for the underperformance of eurozone corporate debt.
We will react opportunistically with regard to interest rate risk and sovereign debt, but we remain cautious on corporate bonds until we see a significant improvement in market liquidity.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
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