ECB Preview

The ECB meets this Thursday and is widely expected to add more stimulus. New staff projections will be released and are likely to emphasize the deteriorating outlook. If the Fed’s open-ended QE is seen as dollar-negative, then increased ECB asset purchases should be euro-negative, as well. That said, the expected increase has been well telegraphed, so near-term pricing should already reflect this.

POSSIBLE NEXT STEPS

1. Further increase and extend Quantitative Easing (QE) – VERY LIKELY NOW. Consensus sees an increase of EUR500 bln in its PEPP this week. The EUR750 bln emergency PEPP introduced in March was a good start, but the ECB should move to a more aggressive stance like the Fed has done. In addition, the PEPP will likely be extended beyond December. The ECB’s balance sheet stands at around EUR5.55 trln ($6.2 trln) at the end of May, up from EUR4.7 trln ($5.17 trln) at the beginning of this year. This 18% increase pales in comparison to 70% increase in the Fed’s balance sheet this year.

2. Jawbone the euro weaker – POSSIBLE NOW. With growing concerns about the economic outlook, a weaker euro really is one of the easiest and surest ways to get some stimulus to the economy. While the ECB professes not to target the exchange rate, that never prevented Trichet or Draghi from making comments that worked to weaken the euro. Of course, without any underlying shift in relative monetary policy stances or economic fundamentals, jawboning typically has limited impact. That said, the euro is nearly flat year to date against the dollar and up only 4% from last month’s low just below $1.08. So far, the move has been neither excessive nor “brutal” but eurozone policymakers will be vigilant.

3. Tweak the rate on its Pandemic Emergency Longer-Term Refinancing Operations (PELTROs) – UNLIKELY NOW, POSSIBLE IN H2. The ECB just introduced this funding mechanism at the April 30 meeting and so it is likely too soon to tweak it. That said, the take-up to the first one on May 20 was disappointing, coming at only EUR851 mln. Because the PELTRO rate is 25 bp below the main refinance rate, we suspect eurozone banks opted instead to secure funding via TLTROs since that rate is now 50 bp below the main refinancing rate.

4. Tweak the rate on its Targeted Longer-Term Refinancing Operations (TLTROs) – UNLIKELY NOW, POSSIBLE IN H2. The ECB just cut the rate again by 25 bp below the main refinance rate at its April 30 so this also seems too soon. The next TLTRO take-up is scheduled for June 18. At the March 12 meeting, the ECB eased TLTRO conditions for by cutting the rate charged by 25 bp and boosting eligibility. Peripheral banks, particularly Italian, were big subscribers of previous TLTROs. While more liquidity would help maintain the health of the banking sector, the impact on lending and activity has been limited.

5. The ECB could cut rates – VERY UNLIKELY NOW, UNLIKELY IN H2. The bank has left the door open to take rates more negative, it’s clearly reluctant to do so due to the potential further harm to the banking sector. Many at the ECB (as well as the BOJ and SNB, it would seem) question the efficacy of negative rates and whether the costs of going more negative outweigh the benefits. WIRP suggests nearly 75% odds of another cut by January 2021. If the bank eventually does cut, however, we expect the ECB will increase so-called “tiering” that allows banks to avoid some of the increased interest charges on their deposits at the ECB.

6. The ECB could activate Outright Monetary Transactions (OMT) – VERY UNLIKELY NOW, UNLIKELY IN H2. Reports suggest many ECB officials were in favor of activating it back in March, but some are pushing back. Despite being part of Draghi’s “whatever it takes” moment, OMT has never been used, in part because of the negative stigma associated with it. By allowing unlimited purchases of member country bonds that are distressed, OMT would be, in our view, another large step towards monetization of fiscal deficits. At this stage, it may be a step too far, especially as the EU is currently working on a fiscal package compromise that would involve some financing by the EU budget as a whole. This should be seen as a baby step towards debt mutualization.

It’s clear from this menu of choices that a lot of room remains for further ECB actions. We expect the ECB to increase QE and jawbone the weaker at this meeting. The next policy meeting after this week is July 16. If stimulus is still needed in H2, the ECB could again increase QE and/or tweak its TLTRO/PELTRO programs. Another rate cut seems very unlikely this year, as does activation of OMT.

 

INVESTMENT OUTLOOK

Charts point to further euro gains near-term. The euro traded at the highest level since March 16 near $1.1230 today. Clean break of the $1.1165 area sets up a test of the March 9 high near $1.15. However, positioning is getting extended. CFTC data shows net euro longs for non-commercial accounts stand at 75.2k contracts. This is down from the April peak near 87,2k but it’s still high. For comparison’s sake, net euro longs stood at -114k in late February and so the swing in positioning has been quick and significant. As a result, we believe further gains will get tougher and tougher from a positioning standpoint.

The ECB will not be happy with a stronger euro. Draghi often pushed back at euro strength during his tenure, let’s see how Lagarde approaches it going forward. If the euro continues to gain, we believe Lagarde is likely to push back against it. As we noted above, this meeting may be too soon for jawboning but policymakers are likely watching it carefully. A significantly stronger euro is the last thing the eurozone needs as it flirts with deflation again.

Indeed, the euro has generally tended to weaken on ECB decision days. In 2018, the euro weakened on 7 of the 8 ECB meeting days. In 2019, the euro strengthened on 5 of the 8 ECB meeting days, though 3 of those days were less than 0.1%. In 2020, the euro weakened on 2 of the 3 scheduled ECB meeting days so far, and also weakened on the emergency meeting March 18, when the Pandemic Emergency Purchase Programme (PEPP) was introduced.

Looking at other asset classes, the behavior on ECB meeting days this year has been very similar. Both STOXX Europe 600 and STOXX Europe Banks have fallen on all three of the 3 scheduled ECB meeting days so far, and also fell on the emergency meeting March 18. Both MSCI EM and MSCI EM FX have fallen on 2 of the three scheduled meeting days as well as on the emergency meeting day.

Peripheral eurozone spreads should continue to fall. Madame Lagarde quickly realized her error in saying that “We are not here to close spreads.” That was and will remain an integral role for the ECB as Italy and other peripheral countries ramp up spending and debt issuance in the coming months. That is another reason to expect the ECB to continue expanding and increasing its asset purchases.

 

TIMELINE OF RECENT DEVELOPMENTS

The ECB released details of its Pandemic Emergency Purchase Programme (PEPP) operations for the first time. The central bank has so far bought EUR234.7 bln through the end of May. EUR186.6 bln was in government bonds, EUR35.4 bln in commercial paper, EUR10.6 bln in corporate bonds, and EUR2.1 bln in covered bonds. The ECB bought EUR37.4 bln of Italian debt since the plan started, which is a higher share of the total country purchases (22%) than what the so-called capital key calls for (15%). The only other significant deviations from the capital key were France (7% below) and Spain (3% above).

France cut its 2020 GDP forecast to -11% from -8% previously. Finance Minister Le Maire said that means the nation must continue its emergency support and pro-business reforms and resist any temptation to raise taxes that could choke off growth even further. This compares to official forecasts for German an Italy of -6.3% and -8%, respectively. To round out the picture of the four biggest eurozone economies, Spain is forecast to contract -9.2% this year.

On May 27, ECB President Lagarde and Vice President De Guindos said eurozone GDP is set to shrink between 8-12%, calling its “mild” scenario out of date. Lagarde added that “We’ll have a better sense in a few days as we publish our numbers in early June, but it’s likely we will be in between the medium and severe scenarios.” France’s forecasts reflect this, and we suspect the other countries will adjust their forecasts downward as well to match.

On May 25, Bank of France Governor Villeroy de Galhau called for the removal of the so-called capital key. Under the capital key, the ECB must buy bonds of all eurozone nations in proportion to the relative size of their economies, which Villeroy said is an “uncalled-for constraint.” This was noteworthy as it comes on the heels of the German court challenge to the ECB’s asset purchases. We doubt the ECB would take such a contentious step whilst still fending off court challenges to its existing programs. However, the fact that Villeroy proposed it suggests that the ECB may more flexible and aggressive than markets are pricing in.

On May 22, the ECB published the account of its April 30 meeting. Officials agreed that a V-shaped recovery could probably be ruled out. As such, “The Governing Council would have to stand ready to adjust the Pandemic Emergency Purchase Program and potentially other instruments if it saw that the scale of the stimulus was falling short of what was needed.” It also introduced Pandemic Emergency Longer-Term Refinancing Operations (PELTROs) to its arsenal in an effort to reduce funding constraints, the first of which was launched last week. The take-up of EUR851 mln was a bit disappointing in light of the -25 bp “costs” to borrow for sixteen months.

On May 5, the German Constitutional Court ruling on ECB QE shocked markets. This case was filed back in 2015 by a group of businessmen and academics and reflects German unease with the concept of QE. The court ruled that ECB bond purchases were legal but violated its obligation to act “proportionately”, which meant the actions were unconstitutional and not backed by EU treaties. The court gave the ECB three months to sort it out by carrying out a “proportionality assessment” of its government debt purchases. If not, then the Bundesbank will no longer be able to participate in the ECB’s bond buying program. Note that this ruling does not impact recently implemented coronavirus measures.

The ruling does nothing to advance European unity, to put it mildly. Back in 2017, the German court asked the European Court of Justice (ECJ) for an interim ruling aimed at limiting the ECB’s leeway to conduct unconventional policy. The EU rejected the restrictive reading of the law by the German court, and yet here we are with a German ruling that seems to thumb its nose at the EU. One law professor sees more conflicts ahead, with national courts more frequently challenging ECJ rulings that they don’t like.

On May 1, the ECB released its scenario analysis for the region. Its mild scenario (now considered obsolete) sees lockdowns end in May and activity recovers soon after, leading to an annual GDP decline of -5% for 2020 and a rebound of 6% in 2021. The medium scenario also includes an end to lockdowns in May but a delay in activity recovery due to strict containment measures, leading to an annual GDP decline of -8% for 2020 and a rebound of 5% in 2021. The severe scenario means that lockdowns will extend to June and longer-term containment measures will remain in place, leading to an annual GDP decline of -12% for 2020 and a rebound of 4% in 2021.