Super Mario (Draghi) pulls another one out of the hat

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On 22 January, the president of the ECB, known in some quarters as Super Mario (Draghi), announced a major expansion of the asset purchase programme of asset-backed securities (ABS) and covered bonds which the eurozone central bank began last year.

Starting in March, the programme will be broadened from private sector securities to include purchases of the eurozone government, agency and quasi-government bonds. The ECB aims to buy a total amount of EUR 60 billion each month until at least September 2016 or until the course of eurozone inflation is consistent with the ECB’s inflation objective of below but close to 2%. The ECB has dropped its previous target of expanding its balance sheet to EUR 3 trillion in favour of an open-ended programme aimed at raising the rate of inflation.

If it ran until September 2016, the extended QE programme would total EUR 1.14 trillion by then; it would exceed this amount if the inflation rate had not moved closer to the ECB target at that point in time. The ECB aims to buy sovereign bonds on a pari passu basis with private investors, while ensuring that it does not end up with a blocking minority. The ECB has set a limit of owning 33% per issuer and 25% per issue.

The programme will be coordinated by the ECB and the purchases will be split between the ECB and eurozone’s national central banks (NCBs) on the basis of each NCB’s share of the ECB’s capital, but only 20% of these purchases will be made on the basis of full risk-sharing among the central banks.

Mario Draghi did not obtain agreement from the governing council for debt mutualisation, but he did get decisions in favour of the “monetisation” of debt. That is to say, one consequence of quantitative easing (QE) will be transfers of a part of the revenues accruing from coupon payments on the sovereign bonds purchased, into their national central bank account, and then on to their government.

Taking into account the current monthly purchases of ABS and covered bonds of EUR 13 billion, purchases of agency debt and bonds issued by European institutions (EIB etc.) should represent 12% of the remaining amount, that is EUR 5.5 billion, while government bonds should account for EUR 41.5 billion of purchases per month and total EUR 800 billion in September 2016.

Furthermore, the ECB has removed the 10bp premium on the main refinance rate for TLTRO (Targeted Longer Term Refinancing Operations) borrowing to slightly improve its attractiveness to banks.

Analysis: the ECB delivers more than expected

The ECB’s extension of QE surpasses the market’s expectations: it will buy bonds run not just for one year, but until the end of September 2016 and this will include agencies, supranational and inflation-linked bonds. Central banks are going to buy on average a large part of gross sovereign bond issuance: 81% of German Bund issuance, for example. So the existing demand for bonds will face a reduced supply leading to a squeeze for core and semi-core government debt. The consequence, in our view, will be a bull flattening of eurozone yield curves. This is likely to mean that to achieve a return of 1%, an investor will have to buy triple-A rated eurozone sovereign debt with a maturity of more than 15 years!

Moreover the ECB’s QE is going to accelerate the convergence of the level of sovereign interest rates in the eurozone’s ‘periphery’ towards those of the core.

Therefore we stick to our 2015 target of risk premiums on Spanish 10-year government bonds of 50bp relative to Bunds, down from 105bp at the start of the year.

The ECB’s goal is to show its commitment to do whatever it takes to support the transmission of monetary policy in the eurozone: this QE programme should ensure a period of stability with yields close to zero for years, which should support investor confidence. It also aims to depreciate the single currency. Successfully, it appears: the euro/dollar exchange rate fell as low as 1.12 on 23 January.

Nevertheless the QE’s effectiveness also carries a risk: linking the bond-buying programme to the rate of inflation means the market expects it to last beyond September 2016 (the market doesn’t expect the rate of inflation to be near the ECB’s target by then). Changes in the inflation rate depend of course on the economic situation and the direction of commodity prices. The euro’s depreciation could also contribute to a bumping up of the rate of inflation. If, for example, crude oil prices were to rebound to EUR 75 per barrel, the eurozone’s CPI inflation rate would rise to above 1% early in 2016 and come closer to the ECB’s target for inflation of 1.5% – 2%.

Written on 23 January 2015

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