ECB: Making QE Work

Published on January 22, 2015

With expectations for some sort of announcement of a sovereign bond purchase quantitative easing program at today’s pivotal European Central Bank Governing Council Meeting soaring since the turn of the year, the focus of markets and analysts had turned to the exact size, shape and timing of a potential program.

And those details clearly matter.

Last Thursday, in SGH Report 1/15/2015, “ECB: Launching QE,” we outlined point by point the key decisions we expected Draghi and the Governing Council were likely to take today. That report was followed by a series of reports and leaks in the press confirming, among other points we had made, a willingness by the ECB to push the envelope above and beyond previous expectations, raising market anticipation and expectations even higher.

The ECB did deliver on every point we had outlined, and on one we had not. And even though there will most certainly be a good deal of handwringing over certain elements of the program, most especially the burden sharing issue, the ECB delivered on the aggressive end of our expectations. Here is how the specifics stack up:

–          We believed the ECB was considering a one year, which could be extended, or two year explicit commitment to monthly bond purchases, leaning to two years. We also expected there to be a slight delay between announcement and start of the purchases. The ECB settled on close to a two year commitment, 19 months, starting in March. 

–          Perhaps even more importantly, while we expected the ECB to shy away from a pure open-ended regime and outline a monthly purchase amount and expected tenor in length for purchases, at the same time we expected Draghi to make it abundantly clear that was not a “cap,” and that the ECB would do more and “reassess” its purchases, including even its balance sheet target (“intention”), if needed. They did, and clarified a willingness to continue purchasing beyond September 2016 if the all-important, ultimate inflation “below, but close to 2%” target is still not in sight.

–          We noted that the intention to expand the ECB balance sheet by approximately 1 trillion Euros would guide the size of the initially announced monthly purchase program but not limit it, and that we felt the ECB would clearly beat what was until then widely understood and leaked to have been the “maximum” option under discussion of 500 billion Euros of sovereign bond purchases. They did so, announcing a 60 billion Euro per month program that while including ABS and Covered Bond Purchases as well, will result in a sovereign bond portion that is substantially higher than the 500 billion figure.

–          Draghi shied away from making hard predictions or commitments on the exact breakdown of those 60 billion Euros of monthly bond purchases, and its composition could indeed shift slightly over time, but pointed to past practice as a guide. For example, the tiny ABS market, which is the ECB’s ideal target for purchases in transmitting stimulus most directly to the most highly stressed parts of the economy, may grow in size – there has for example been some recent discussion by Italian authorities of wrapping a whopping 50 billion Euros of bank “junk” loans into an ABS that would be guaranteed by the government, heavily discounted (by up to 60%), to be then sold to the ECB. 

–          But for now the ABS market is for monetary policy purposes negligible. The ECB is, however, purchasing covered bonds in the Covered Bond Purchase Program (CBPP3) at a clip of approximately 12-13 billion Euros per month.

–         And in addition to CBs we had also expected the ECB to buy supranational, for example EIB, bonds, which they announced they would, stating that this would comprise 12% of the purchases. That comes out to 5 billion Euros per month, and leaves sovereign bond purchases in the 40-45 billion range, depending on whether the CBPP3 (and ABS) purchases are closer to 10 or 15 billion Euros. That comes out to roughly 750-850 billion in sovereign purchases, with a whole lot of other purchases alongside as well.

–          The ECB announced it would have no problem in buying bonds that carried a negative rate, which we wrote they would, and did not adjust (hike) the negative deposit rate upwards as some analysts apparently thought they might do for technical reasons in order to allow for the purchase of those bonds. Frankly that never made any sense to us. We also expected them to buy bonds across the curve, which includes out to the 30 year sector, which they announced they would.

–          What we did not expect was for the ECB to shave the 10 basis point spread it was charging on TLTRO loans to the banks, and that is quite frankly because we had plain forgotten about that. Removing that surcharge of course makes eminent sense, and it is a relatively minor but nevertheless helpful easing measure that had been speculated on by analysts for months before everyone’s focus (including ours) turned to the big bazooka.

–          As to quality, the ECB announced, as we expected, that it would buy investment grade bonds. And while the specifics surrounding Greece were left a bit vague, it is clear they will not buy Greek bonds for now, but can buy them later once the country program review is finalized, and once there is some issuance that can actually be bought without “owning” the market (rather conveniently, not until July). That assumes compliance from whatever new government might then be in place (ahem…). That is a more than reasonable solution.

–          We also included in our report, and this would be a key element of the QE program in the hypothetical case that the ECB needs to deliver even more than it has already, an expectation that the ECB would have a 30% cap on purchases from any given sovereign risk akin to the Federal Reserve’s 35% SOMA bond purchase issuance limits in its QE programs.

–          We subsequently saw very little if any discussion or analysis of this metric anywhere except in a German article that appeared, unattributed, rather curiously right after Draghi’s meeting with German Chancellor Angel Merkel. That article had, buried in it, a “technical” assurance purchases would be no more that 20-25% of an issuance.

–          The discrepancy between our number and the German paper’s is that they refer to two different metrics. The ECB indeed set a 30% upper limit on bond purchases per issuer (in the case of a sovereign, that means per country), and 25% for a specific issue.

–          We were a bit surprised that Draghi chose to go public with these numbers, but it is clearly the correct decision on a transparency level and mandate perspective. The European Court of Justice Advocate General opinion on the OMT the week before had allowed the ECB wide discretion on whether or not to go public with their internal guidelines for what constituted “owning” any given market or issue, but Draghi and the Governing Council are clearly, and rightly, looking to put this issue to rest in front of the inevitable lawsuit that will come from the CSU/AfD/IFO wing nuts (it has started already).

–          We suspect Draghi and some of his fellow board members may be pleased that we left the discussion over risk sharing, which has been the subject of so much analysis and angst, to the very end of this report.

–          That is because we have shared the view that a compromise on the “ideal” of collective risk sharing was a price well worth paying for greater consensus on delivering a QE program, in size, and critically, also with the “unanimous consent” on the legality of the QE program – as constructed – that Draghi cleverly pushed through today.  

–          On the risk sharing topic, suffice it to say we feel it is highly unlikely the distinction between whether bonds are held on the ECB or Bank of Italy balance sheets and the liability of potential default risk will ever become a matter of concern in the scheme of things, even though there are limitless theoretical breakup possibilities that can be construed. And in the more realistic but still improbable likelihood Greece were to become a problem for political reasons specific to Greece, could it not at that point be to some extent ring fenced?

–          We believe after the initial shock over the burden sharing deliberations within the ECB, most of the market has come around to our thinking and has been voting with its feet – and wallets. That leads to the very relevant question of why the ECB even bothered to keep 8% of the sovereign bond purchases on its balance sheet? On that, Draghi was very clear. It was simply meant as a symbolic gesture towards collective responsibility.

–          We would reiterate and conclude on a final note on collective risk sharing – which is critically important to the future of Eurozone unity – that the ECB’s objective for this program is to stimulate the Eurozone economy with the most effective program possible, within its mandate. While sending a stronger signal on political cohesiveness would obviously have been preferable, it is not the job of the ECB to engage in that battle. It is that of the governments and fiscal authorities. The fact that the ECB had to step into the breach to save the Euro from break up with a “whatever it takes” pledge during the 2011-12 crisis due to a void in political and fiscal leadership may sometimes make markets lose sight of that delineation of responsibilities.

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