At next week’s policy meeting we expect the ECB (European Central Bank) to deliver on its October pre-commitment by upping the dose of monetary policy stimulus with a sizeable QE (Quantitative Easing) top-up as well as further banking sector support. The positive news that has emerged on the vaccine front in recent weeks will not fundamentally alter that plan, but in our view should influence the parameters of the December policy decisions. After all, while vaccine breakthroughs will have no sizeable impact on the immediate short-term outlook, downside risks to the outlook for economic growth and inflation in 2021 and beyond have notably reduced as a result. Hence, the ECB’s December decision will be all about striking a balance between a bold policy response that continues to put a firm lid on sovereign and private refinancing costs, while at the same time allowing for sufficient flexibility in case upside risks to the macro outlook materialize as soon as H2 2021.
On the asset purchase front, the ECB – applying key lessons from the pandemic management playbook – should opt for a big and bold announcement next week with flexible implementation across time and policy tools. With borrowing costs in many Eurozone countries at record lows, the key focus of the ECB should be on cementing and extending these favorable conditions in the context of a more protracted economic crisis. We think a December QE top-up to the tune of EUR500bn should do the trick. In practice, this will mean increasing the ECB balance sheet by another EUR1.6trn in QE purchases in 2021, bringing the total spent on asset purchases between March 2020 and December 2021 to a cool EUR2.4trn. Flexibility is key when it comes to implementation. First of all, the QE reload should not be understood as a target but rather a cap on asset purchases. After all, the “threat” of a sizeable QE envelope to be deployed at any time to put out fires in bond markets has, in our view, a greater spread compressing impact than a set monthly pace of asset purchases. Second, given the high uncertainty around the outlook, the ECB would get the biggest bang for its buck if it opted for some constructive ambiguity and put forward a flexible QE envelope to be spent across the APP as well as the PEPP, as deemed most appropriate in the coming months.
Reinforcing support for the banking sector, where the worst is still to come. just as 2020 was all about tackling liquidity risk, 2021 will be all about mitigating credit risk. Once again monetary policy is not in the policy driving seat here; rather it's up to more fiscal support, for instance via governments extending state-guaranteed loans, and further regulatory forbearance to address the rise in NPLs and capital concerns to make a real difference. Tweaking the TLTRO (targeted longer-term refinancing operations) modalities by itself, is unlikely to boost lending by much, but in tandem with other measures could help soften the expected tightening in credit conditions. Hence, next week we expect the ECB to announce additional tender operations and to make the conditions more generous. There are many options when it comes to tweaking the TLTRO modalities; however, we think in particular (i) a lengthening of the period in which banks can borrow at the most favorable rate to end-2021, (ii) an increase in the borrowing allowance and (iii) an extension of the TLTRO maturity from three years to four to five years would go a long way in cementing the favorable access to funding.
The ECB’s continued bond-buying spree will see the sovereign debt market supply continue to shrink in 2021 despite another record-year of debt issuance. Given the current dynamic between net issuance and net QE purchases, we think that the Eurosystem is on course to hold almost 50% of Eurozone long-term sovereign bonds by the end of 2021. Currently we estimate the yield compression for the 10y Eurozone benchmark at 165bp. According to our calculations, the QE-induced yield compression could rise to 180bp by the end of next year. In that context, even if some inflation repricing in terms of levels (inflation expectation) or volatility (inflation risk premium) might occur next year with the economic recovery unfolding, the yield of 10y German Bund may hardly rise above the -0.50% threshold.
The impact of the Covid-19 crisis on Eurozone yields will be felt for more than a decade. The compression effect is here to stay, being structural by nature. Indeed, even if the ECB would at some point taper or end sovereign bond net purchases, a multi-year phase of full portfolio reinvestment would likely still follow to avoid monetary conditions tightening too fast. Our calculations suggest that if the ECB stopped buying bonds today and did not commit to reinvestment, 10y yields could rise up to 70bps within 12 months. Meanwhile a full reinvestment period of three years would contain the upward pressure at 20bps only. We also see that it will take around 10 to 15 years for the dampening effects to become insignificant. This means that even when the Covid-19 crisis is eventually over, the monetary policy response to this crisis will leave a long-lasting mark on Eurozone sovereign bond markets.