ECB Preview: Draghing On
September 6, 2017

Andrew Bosomworth, Head of PIMCO portfolio management in Germany, ahead of the European Central Bank meeting tomorrow.

We expect ECB President Mario Draghi to signal broad, high-level forthcoming changes to its quantitative easing (QE) programme on Thursday and to deliver details at the October 26 Governing Council meeting. Staff macro forecasts should see GDP (gross domestic product) notched up and the 2019 HICP (harmonized index of consumer prices) forecast notched down 0.1 percent to 1.5 percent, owing to the stronger euro, and presenting the ECB with a dilemma in terms of extending QE versus running up against technical limits on how many bonds it can buy.

Our baseline foresees the ECB reducing the monthly run-rate of net asset purchases to EUR 40 billion per month effective January 2018, to be reviewed in spring 2018 for eventual extension and wind-down to zero by end 2018. We think this round of QE will total between EUR 200-EUR 400 billion, bringing total QE purchases close to 25 percent of GDP. We expect ECB will apply the capital key to net purchases as well as reinvestments, which will tilt the distribution of QE flows in 2018 toward French and Italian government bonds away from bunds, owing to the latter's shorter duration in the overall portfolio, as well as extending the life of QE before reaching the binding 33 percent limits.

We think the ECB will strengthen forward guidance to reaffirm that policy rates will remain unchanged well beyond the end of net asset purchases. Looking further out, we think the ECB will deliver the first deposit facility rate hike of 15 basis points around mid-2019 and begin to run-off its balance sheet from 2020 onward, leaving approximately EUR 2 trillion excess liquidity in the system over the secular horizon.

Some commentators suggest Draghi could drag out the taper details until the December 14 meeting. That would not conform to previous longer lead-times between announcement and implementation and we don't think it matters owing to the likely dovish forward guidance. 

The policy changes we anticipate point to a dovish taper. At face value tapering poses a headwind for rates and spreads. Delivered in the manner outlined above amidst robust growth and moderate inflation, the ECB's gradual exit should anchor frontend interest rates relative to longer tenors and marginally support periphery assets relative to bunds, thereby mitigating tapering's impact.

Portfolio construction implications are to concentrate duration exposure in middle of the yield curve, e.g. around five-year maturities and to be broadly neutral periphery exposure.

While money market rates have almost reversed the rise in yields following Draghi's June speech in Sintra, we think they can continue grinding lower owing what we expect will be a tapering wrapped in dovish forward guidance combined with the structural downward pull of negative policy rates combined with excess liquidity.

Medium-Tem Policy Baseline

We expect the ECB to sequence the exit in four steps by 1) adjusting forward guidance, 2) tapering QE, 3) normalizing policy rates, 4) reducing the balance sheet:

Strengthening forward guidance to mitigate a tightening of financial conditions

         The ECB has already modified forward guidance to restore balanced outlook to growth and interest rate policy

         As it moves now to address tapering, we expect president Draghi to emphasize that rates will remain low for long as well as that QE can be increased if warranted, eg by retaining the sentences:

‒         "The Governing Council expects the key ECB interest rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases."

‒         "If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the programme in terms of size and/or duration."

Tapering asset purchases in 2018

         We expect the ECB to taper net purchases to EUR 40 billion per month effective from January to June 2018, to be revised in Spring 2018 and eventually prolonged but wound down to zero by December next year

         We expect ECB to retain optionality around the length of QE by not yet pre-committing to a path to end purchases, but rather to adjust the quantity and date in the sentence:

‒        "Regarding non-standard monetary policy measures, the Governing Council confirms that the net asset purchases, at the current monthly pace of EUR 60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim."

         We expect the capital key to apply to net asset purchases as well as reinvestments, i.e. de facto to gross asset purchases, which will tilt the stock of assets toward French and Italian government bonds away from bunds, owing to the latter's shorter portfolio duration and higher redemptions in 2018. Tapering and applying the capital key to gross asset purchases will extend the period by which time the ECB reaches the binding 33 percent issue/issuer limits on bunds, possibly in 2019

         We expect the overall size of this fourth round of QE to total between EUR 200 billion-EUR 400 billion, bringing total QE purchases to about 25 percent of GDP

Rates normalization beginning mid-2019 and balance sheet reduction from 2020 onward

         We expect the ECB to raise the deposit facility rate by 0.15 percentage points to -0.25 percent around mid-2019, restoring symmetry to the standing facility rates, and to discontinue reinvesting maturing bonds form 2020 onward

Money Market Expectations

The euro overnight interest rates swap (OIS) market prices a 15bps deposit facility hike to -0.25 percent around August-September 2019, which is plausible. Thereafter, the OIS curve prices only one 25bps rate hike per year toward the end of 2020 and 2021 to 0 percent and 0.25 percent respectively, amounting to 65bps of cumulative hikes over the next four years. While this represents little term premium at first sight, and an uninterrupted continuation of current growth momentum would warrant more rate hikes, we are cognizant of the rising probability of recession as the global credit cycle matures and other pivot points that could disrupt global growth over the secular horizon.





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Andrew Bosomworth, Head of PIMCO portfolio management in Germany, ahead of the European Central Bank meeting tomorrow.

We expect ECB President Mario Draghi to signal broad, high-level forthcoming changes to its quantitative easing (QE) programme on Thursday and to deliver details at the October 26 Governing Council meeting. Staff macro forecasts should see GDP (gross domestic product) notched up and the 2019 HICP (harmonized index of consumer prices) forecast notched down 0.1 percent to 1.5 percent, owing to the stronger euro, and presenting the ECB with a dilemma in terms of extending QE versus running up against technical limits on how many bonds it can buy.

Our baseline foresees the ECB reducing the monthly run-rate of net asset purchases to EUR 40 billion per month effective January 2018, to be reviewed in spring 2018 for eventual extension and wind-down to zero by end 2018. We think this round of QE will total between EUR 200-EUR 400 billion, bringing total QE purchases close to 25 percent of GDP. We expect ECB will apply the capital key to net purchases as well as reinvestments, which will tilt the distribution of QE flows in 2018 toward French and Italian government bonds away from bunds, owing to the latter's shorter duration in the overall portfolio, as well as extending the life of QE before reaching the binding 33 percent limits.

We think the ECB will strengthen forward guidance to reaffirm that policy rates will remain unchanged well beyond the end of net asset purchases. Looking further out, we think the ECB will deliver the first deposit facility rate hike of 15 basis points around mid-2019 and begin to run-off its balance sheet from 2020 onward, leaving approximately EUR 2 trillion excess liquidity in the system over the secular horizon.

Some commentators suggest Draghi could drag out the taper details until the December 14 meeting. That would not conform to previous longer lead-times between announcement and implementation and we don't think it matters owing to the likely dovish forward guidance. 

The policy changes we anticipate point to a dovish taper. At face value tapering poses a headwind for rates and spreads. Delivered in the manner outlined above amidst robust growth and moderate inflation, the ECB's gradual exit should anchor frontend interest rates relative to longer tenors and marginally support periphery assets relative to bunds, thereby mitigating tapering's impact.

Portfolio construction implications are to concentrate duration exposure in middle of the yield curve, e.g. around five-year maturities and to be broadly neutral periphery exposure.

While money market rates have almost reversed the rise in yields following Draghi's June speech in Sintra, we think they can continue grinding lower owing what we expect will be a tapering wrapped in dovish forward guidance combined with the structural downward pull of negative policy rates combined with excess liquidity.

Medium-Tem Policy Baseline

We expect the ECB to sequence the exit in four steps by 1) adjusting forward guidance, 2) tapering QE, 3) normalizing policy rates, 4) reducing the balance sheet:

Strengthening forward guidance to mitigate a tightening of financial conditions

         The ECB has already modified forward guidance to restore balanced outlook to growth and interest rate policy

         As it moves now to address tapering, we expect president Draghi to emphasize that rates will remain low for long as well as that QE can be increased if warranted, eg by retaining the sentences:

‒         "The Governing Council expects the key ECB interest rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases."

‒         "If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the programme in terms of size and/or duration."

Tapering asset purchases in 2018

         We expect the ECB to taper net purchases to EUR 40 billion per month effective from January to June 2018, to be revised in Spring 2018 and eventually prolonged but wound down to zero by December next year

         We expect ECB to retain optionality around the length of QE by not yet pre-committing to a path to end purchases, but rather to adjust the quantity and date in the sentence:

‒        "Regarding non-standard monetary policy measures, the Governing Council confirms that the net asset purchases, at the current monthly pace of EUR 60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim."

         We expect the capital key to apply to net asset purchases as well as reinvestments, i.e. de facto to gross asset purchases, which will tilt the stock of assets toward French and Italian government bonds away from bunds, owing to the latter's shorter portfolio duration and higher redemptions in 2018. Tapering and applying the capital key to gross asset purchases will extend the period by which time the ECB reaches the binding 33 percent issue/issuer limits on bunds, possibly in 2019

         We expect the overall size of this fourth round of QE to total between EUR 200 billion-EUR 400 billion, bringing total QE purchases to about 25 percent of GDP

Rates normalization beginning mid-2019 and balance sheet reduction from 2020 onward

         We expect the ECB to raise the deposit facility rate by 0.15 percentage points to -0.25 percent around mid-2019, restoring symmetry to the standing facility rates, and to discontinue reinvesting maturing bonds form 2020 onward

Money Market Expectations

The euro overnight interest rates swap (OIS) market prices a 15bps deposit facility hike to -0.25 percent around August-September 2019, which is plausible. Thereafter, the OIS curve prices only one 25bps rate hike per year toward the end of 2020 and 2021 to 0 percent and 0.25 percent respectively, amounting to 65bps of cumulative hikes over the next four years. While this represents little term premium at first sight, and an uninterrupted continuation of current growth momentum would warrant more rate hikes, we are cognizant of the rising probability of recession as the global credit cycle matures and other pivot points that could disrupt global growth over the secular horizon.



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