ECB: A Potential Pause

Published on May 26, 2020

A host of European Central Bank Governors and Board Members, including Chief Economist Philip Lane and the Banque de France’s Francois Villeroy de Galhau, have assured markets that the ECB will not hesitate to add to its already massive stimulus package to support the COVID-19 devastated Eurozone economy.

That has raised expectations in markets that the size of the 750 billion Euro supplemental PEPP “Pandemic Emergency Purchase Program” that was rolled out in March of this year will be increased at the upcoming Governing Council meeting on Thursday, June 4.

** Our understanding is that when the Governing Council meets next week one of the policy options on the table will indeed include a bump up in the PEPP. But another option presented by the Chief Economist will be a hold, and based on our latest soundings, our sense is that the ECB is likely hold off on hiking its bond purchase program – at least for now.

** With yields well under control, and plenty of headroom and flexibility already in the “overall envelope” of 750 billion euros in bond purchases committed to the program, there is no technical reason at this juncture to raise the PEPP limits except as a signaling device to markets. Furthermore, with bond purchases typically tailing off in the summer, that easily provides ECB officials breathing room until the July 16 meeting to further assess the economic fallout and policy responses to date to the COVID-19 recession, and to make any further adjustments at that point to the size or composition of the program as needed.

** The economic assessment for the Eurozone will, without a doubt, be dire, with growth not being seen to resume to 2019 levels until the end of 2021, if not later. With that in mind, ECB officials are sensitive to the possibility that further actions may be needed down the road if strains emerge in other, including non-banking, areas of the financial sector from a prolonged downturn.

** Our understanding is that the Governing Council will assess its collateral requirements for bond purchases next week, and very likely loosen those further to expand the universe of eligible bonds. The ECB already accepts banks’ packaged loans, and its credit-focused efforts will continue to focus on improving the transmission mechanism of its monetary policy through the Eurozone’s critical banking sector.

** But unlike the Federal Reserve, the ECB purchases will not include a deep dive into junk bond territory. ECB officials will not rule that out as an option down the road, if needed, but buying corporate junk is not a current priority of Frankfurt’s, and we would, for now, categorically rule that out.

** There has also been renewed focus on the “Capital Key” system and national distribution of the ECB’s sovereign bond purchases, aggravated, if anything, by a ruling on May 5 by the German Constitutional Court yet again demanding the ECB explain the monetary policy rationale behind its QE program. But we expect no official change to the current system next week.

** In effect the PEPP already is being conducted with little to no regard to the Capital Key, concentrated in large part already on Italian BTPs and other bonds experiencing some stress earlier this year, and with great success in ensuring a “reasonable” divergence in spreads between highly indebted Eurozone members and their northern colleagues. So other than to defy or pick another unnecessary fight with the German court in Karlsruhe, there really is no need for any formal change on a policy that is being loosely followed, if at all, already.

** Finally, the ECB will keep an eye out for further assistance on the fiscal side, including on the details of a proposed pan-Euro “Recovery Fund” that is to be levered off the European Union budget (see SGH 4/23/20, “EU: Hashing out a Recovery Fund”).

** With disagreements rising between a more generous, 500 billion euro Macron-Merkel Recovery Fund proposal focusing on grants, and a loan-based alternative submitted by a group of member states since dubbed the “Frugal Four,” the European Commission is slated to offer its own version of the Recovery Fund tomorrow.

** These disagreements will not be resolved by the Commission tomorrow, but sources indicate that Recovery Fund negotiations are generally moving in the right direction, even while likely to take some more weeks to resolve. For starters, there is always a good deal of horse trading around the Multiannual Financial Framework itself, or “MFF,” as the EU 7-year budget is known, and that is before even getting to the question of “loans versus grants” in setting up the Recovery Fund.

** We are not yet certain how that is going to ultimately resolve itself, but we would note that even while the “Frugal Four” have drawn a line in the sand on giving out collectively financed member state grants, none are expressing opposition to the Recovery Fund per se, and we expect it will all be resolved in due time. Some sources expect negotiations to probably drag out into early July.

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