Investment bank BNP Paribas has predicted a round of full-blown quantitative easing (QE) by the European Central Bank (ECB), starting at the beginning of the third quarter.
Laurence Mutkin, London-based global head of G10 rates strategy at the French bank, told IPE he was consequently bullish on the 3-7 year part of the European supranational bond curve.
He also indicated that it would affect the relative performance of interest rate swaps against bonds.
Disinflation pressures will leave the central bank with no choice but to pursue the unconventional monetary policy already at work in the US, the UK and Japan.
The ECB did purchase government bonds in 2011 as part of its Securities Markets Programme (SMP), but these purchases were sterilised with deposit auctions.
“The ECB will have to move to full QE because we just don’t think that other measures are going to be particularly effective,” Mutkin said.
The central bank could push its deposit rate below zero, lower its refinancing rate or offer another round of long-term refinancing operations (LTRO).
While the ECB has been “operationally ready” to introduce a negative deposit rate for some time, Mutkin said, the lack of excess liquidity in the monetary system – now that so much of the original LTRO has been repaid – would make such a move “almost entirely symbolic”.
When there is a lot of excess liquidity in markets, the overnight interest rate paid between commercial banks disconnects from the ECB’s refinancing rate and falls towards its deposit rate.
But as excess liquidity dries up – and especially as it falls below about €150bn, as it has recently – those market interest rates begin to re-connect with the refinancing rate.
“The deposit rate is becoming less influential on the market level of interest rates, which makes taking it negative easier to do, but less effective,” Mutkin explained.
The ECB did cut its refinancing rate to 0.25% in November 2013, apparently in anticipation of this automatic rise in overnight rates back towards that benchmark.
“The ECB could cut the refi rate to 15 or 10 basis points, but does 10 or 15 basis points off of the potential peak overnight rate really change the monetary environment?” Mutkin asked.
A new round of LTRO could provide the liquidity conditions in which a negative deposit rate would have renewed effectiveness, but he thinks the ECB is reluctant to provide funding for banks to expand their balance sheets by buying zero risk-weighted assets.
“[Ewald] Nowotny has suggested that there might be some conditional long-term lending, perhaps along the lines of the UK’s Funding For Lending scheme, but unconditional long-term refinancing no longer seems to be on the agenda,” he said.
The ongoing threat of disinflation will spur government bond purchases, he concluded, probably weighted according to the ECB’s ‘capital key’.
The biggest providers of capital to the ECB are Germany, France and Italy, but Germany’s outstanding government debt as a proportion of its GDP is much lower than that of Italy or France.
The ECB would therefore buy German government bonds in disproportionate amounts, Mutkin suggested.
To balance that out, it will likely follow the precedent of the European Stability Mechanism’s investment policy and buy supranational and agency bonds as well as sovereign bonds, he added, and focus on the 0-3 year part of the curve to appease the more orthodox policymakers who harbour long-term worries about inflation.
“Because of the desired portfolio re-balancing effect, those who have their three-year paper bought by the central bank will have to go and buy four-year paper from other investors, and so on,” he added.
“For that reason, investors should probably think that supranationals will outperform, and that the best part of the curve to be sitting in would be the 3-7 years.”
Mutkin does not think QE will necessarily push core euro-zone government bond yields down.
He points to evidence that QE in the US and the UK, once underway, actually pushed yields up – thanks to the third factor of market expectations for economic recovery and rate hikes having a greater impact than the supply-and-demand balance.
However, he does expect relative outperformance against interest rate swaps, where rates would be set to rise.
“What we are talking about is outperformance of spread products and government bonds against the true risk-free rate, which is represented by swaps, which reflect market expectations of where the EONIA rate is going,” Mutkin told IPE.
Because the notional principal of many swaps is discounted using EONIA, a rising EONIA rate would result in rising swap rates.
That could present an opportunity to move liability-hedging portfolios out of swaps and into cash-market bonds, especially in those parts of the curve identified by Mutkin as most likely to respond to QE purchases.
John Stopford, co-head of fixed income and currency at Investec Asset Management, also raised the prospect of QE at his firm’s 2014 Outlook press conference in London on 21 January, while discussing prospects for US dollar strength.
“The latest surveys suggest that only about 8% of the market puts a high level of probability on QE from the ECB,” he said. “It is more like a one-in-four probability.”
A Reuters poll of economists in November found only 20% entertaining the possibility the ECB would stop sterilising its bond purchases.