Overview
Indefinite QE
Just nine months after the previous QE programme was halted, the ECB announced that purchases will restart in November. Moreover, the bank also cut deposit rates by 10 basis points and extended its forward guidance.
So, was ECB president Mario Draghi dovish enough? The numbers were underwhelming as the market had expected a more significant package, with talk of 40-60 billion euros of purchases per month. While the indefinite or state contingent nature of this QE is positive and will dampen average market volatility over a multi-month period, we believe the size of 20 billion euros will not be enough to reduce short-term bouts of volatility.
Source: ECB, Fidelity International, September 2019
Not enough support for sovereign bonds
Given many market participants were expecting over 40 billion euros of purchases for at least 12 months, we believe the modest size of the new package to be insufficient to support already expensive valuations in many core/semi-core government bonds. We would expect this to lead to some widening in the spread between semi-core countries and Germany. At the margin, this package should support long-end spreads in periphery Eurozone countries by reducing volatility.
As for Italy, QE 2.0 is likely to be sufficient to keep yields in check if the new government plays by the EU books when it comes to budget negotiations. However, if the government starts talking up the prospect of a deficit above 2.5 per cent, or if there’s new uncertainty due to Italexit talk, then this level of QE will not provide much support, in the same way that it did not really help during the second quarter of 2018 when Italy’s deficit plans caused a row with the European Commission.
Fiscal policy is the next big game in town
The modest size of the new QE and Draghi’s repeated reference to fiscal policy as the next tool to be deployed by member states suggests that curve flattening has run its course. We are of the view that it is unlikely for fiscal policy of any meaningful size to happen anytime soon, and that even its first iteration is likely to prove a disappointment for the market. However, this expectation of greater fiscal leeway should be enough for investors to think twice about buying low yielding 30-year bonds and should be priced in through steeper yield curves.
Impact on credit markets
Unless the composition of the Asset Purchase Programme (APP) changes, the run rate for the Corporate Sector Purchase Programme (CSPP) is expected to be around 2-3 billion euros; half of what the market was expecting. In fact, this figure may be even lower than the run rate during the wind down of QE 1.0 at the end of the fourth quarter of 2018.
So overall, we do not think that expected run rate of CSPP 2.0 is enough to provide material support for credit spreads. In fact, it is very likely that the new demand coming from the ECB will be more than offset by supply from European and non-European companies. Furthermore, as CSPP is due to start in November, the market is quite likely to be overwhelmed by deals in the next six weeks, further weighing on already stretched valuations.
Conclusion
Our view is that the market was priced for perfection in the run up to the ECB meeting. The stimulus package in its current form is not enough to support already expensive valuations both in the government and credit space, and there is room for some retracement.
However, if the size of the CSPP is expanded (from 2-3 billion euros to more than 5 billion euros a month) or external events such as a ‘hard Brexit’ or US tariffs on European auto companies materialise, the ECB will certainly have room to expand this latest QE programme, keeping valuations in check.
