BY PICTET WEALTH MANAGEMENT
This Wednesday’s (15 June) unscheduled meeting of the ECB’s Governing Council was very important, if only in terms of timing and signal, following Isabel Schnabel’s bold speech on fragmentation on Tuesday.
Our impression is that the ECB is now willing to act pre-emptively, before peripheral spreads get out of control.
True, an explicit signal on flexible PEPP reinvestments and the decision to “task the relevant committees” were long overdue, and should have been part of last week’s policy announcements.
But, the speed of the response, with BTP spreads arguably still close to manageable levels, marks a major difference with the old ECB reaction function.
It does suggest that the ECB’s pain threshold has been reached.
Now the devil will be in the details, but we believe that the ECB will have no choice but to deliver on its promises.
If and when they do, the flip side of stable peripheral spreads will be a faster pace of rate hikes, in our view. After the June meeting we were expecting a 25bp hike in July, 50bp in September, followed by back-to-back 25bp hikes in October and December.
We are putting our forecasts under review and will send an update after the Fed.
PEPP reinvestments: how much support for BTPs?
We estimate the total amount of PEPP redemptions in public bonds at about €200bn in 2022, rising closer to €250bn in 2023. Contrary to the PSPP, the ECB does not publish the monthly profile of PEPP redemptions (only backward-looking numbers in the weekly financial statements), which have to be estimated using assumptions about the share of T-bills, in particular. Moreover, we have to wait for the bi-monthly breakdown of asset purchases to see how much the ECB deviated from capital keys.
It is possible that the ECB starts publishing a more detailed breakdown of PEPP redemptions and reinvestments with the objective of providing more clarity to markets.
Assuming up to €20bn in PEPP redemptions per month, the amount that could effectively be redirected to Italy will be much smaller. First, Italian BTP redemptions have to be removed from the aggregate, being reinvested in the same jurisdiction. Second, other peripheral markets will likely need some support too, including Greece. Third, the ECB remains committed to converging back towards capital keys over the longer term, which de facto limits the near-term flexibility unless the rules are changed. Fourth, the bulk of PEPP purchases is done by National Central Banks, and the ECB would need to increase coordination with them.
In the end, we estimate that the ECB could front-load up to €10bn in PEPP reinvestments per month initially that could be redirected to the periphery, in case of severe market stress. This could happen in the first few months of interventions, before additional BTP purchases could be scaled down once a new tool is deployed.
To put things in perspective, the Italian treasury faces around €120bn in BTP redemptions for the rest of the year, and around €270bn in 2013 (excluding new funding needs), of which up to 20% are held by the Bank of Italy and will be reinvested mechanically.
The ECB’s capacity in terms of flexible PEPP reinvestments is not insignificant, but probably falls short of the support needed in case of severe fragmentation and protracted market dislocations.
In our view, a game-changer would see the ECB abandon the objective to converge back to capital keys in terms of PEPP holdings over the medium-term. This would free up additional capacity for core bonds redemptions to be reinvested in peripheral markets.
New anti-fragmentation tool: timing and modalities
Isabel Schnabel provided some ideas as to what a new backstop could look like, in line with previous comments from French Governor François Villeroy de Galhau. Schnabel said that a new tool would be different than previous ones (SMP, OMT, PSPP or PEPP), “with different conditions, duration and safeguards to remain firmly within our mandate”.
The decision to task the relevant committees and services in order to “accelerate the completion of the design of a new anti-fragmentation instrument” suggests that the ECB will make a formal announcement at the 21 July meeting, if not before in case of further spreads widening post Fed.
Our best guess is that the new tool will look a bit like OMT, but with some differences:
– no ex ante limit on the total amount of purchases and, crucially, no consolidation of holdings with other asset purchase programmes (like under the PEPP) to avoid any constraints linked to issuer limits;
– full flexibility in terms of allocation of purchases across time and jurisdictions;
– light conditionality based on member states’ compliance with the European semester and the NGEU framework, essentially making any compliant country eligible to ECB purchases;
– pending eligibility, full discretion on the ECB’s side (or Executive Board) in terms of the timing and amount of purchases;
– shorter maturities than under the PEPP, but longer than under the OMT, say 2 to 5-year maturities to be consistent with the ECB’s focus on monetary policy transmission;
– sterilisation of purchases: while this looks politically correct on paper, implementation may be more challenging in a context of ample excess liquidity and upcoming TLTRO repayments, but the ECB might find a way using ad hoc facilities at higher rates, or even the issuance of debt certificates which is allowed by its statutes; other “safeguards” could include a commitment for this tool to be terminated around the end of the normalisation process, if not to sell the bonds at a later stage;
– one key question is whether the ECB will ultimately disclose the criteria defining fragmentation and the (spreads) levels justifying interventions; we suspect they will remain vague about that.