An aggressive cut to government debt purchases is the only way to keep spreads contained over the medium term, bond manager Nick Wall says.
The ECB holds a pivotal meeting on 26 October, when the monetary guardian is likely to decide the future path of its quantitative easing programme.
The current round of asset purchases is due to run until the end of the year. Investor expectations tend to centre on either a six-month extension at a pace of €40bn per month, down from the current rate of €60bn, or a nine-month extension at a pace of €30bn per month. There are inherent dangers in both approaches.
Under the current programme, the ECB is limited to buying up to 33 per cent of bonds from one particular issuer and 33 per cent of each bond issue. The central bank also purchases the debt of euro area members according to their contribution to its capital key, which roughly reflects their weightings in the region’s GDP. This means German debt makes up around 27 per cent of purchases. Given that Germany’s debt/GDP ratio is low by European standards, and it runs a broadly balanced budget, the ECB is fast approaching its own constraints. What can it do?
Could the central bank ditch the capital key? It has diverged from this framework with smaller countries, such as Ireland, Latvia and Portugal, allocating purchases across other sovereigns. Due to the size of the German economy, however, any reallocation of purchases away from it could be interpreted, in Germany and other like-minded countries, as sovereign financing rather than capital key slippage.
Given the German election result, in which the Eurosceptic AFD party surged, there would probably be a serious backlash against the ECB buying Italian or French debt instead of German bunds. This would be particularly likely if Christian Lindner, who leads the Free Democrats Party and takes a dim view of any drift towards fiscal union, becomes finance minister. Moreover, such a move by the central bank could be deemed illegitimate and subject to legal challenge, not least at Germany’s Constitutional Court.
In any event, The ECB’s statements on its purchase limits have been consistent: the central bank will not break them. It seems likely, therefore, that the programme will continue under its current framework.
In this scenario, after buying €40bn of government bonds per month for six months, or €30bn per month for nine months, the ECB would be left with only another six months of possible Bund purchases (assuming the same pace of buying was continued).
This may not seem like an issue today, after all growth is strong and credit spreads are tight. Should the economy slow, however, or should a political shock strike a highly indebted economy, the ECB would be left with very little firepower with which to respond.
Credit spreads have been incredibly well behaved in the last few years, in part because of the central bank’s stimulus measures, but also because investors expect the ECB to intervene if markets turn nasty.
When the world worried about China’s devaluation in early 2016, sparking a selloff in risk assets, the ECB stepped in to increase purchases and began buying corporate bonds. Following the Brexit vote, peripheral European bonds rallied back strongly after initial declines, on a belief that the ECB would act if markets became disorderly.
That belief in the ECB would be shaken if it could only buy bonds for a further six months (on the assumption the central bank will not seek to reduce its balance sheet in the near future). This would leave risky bonds vulnerable, with sovereign spreads likely to widen as the purchases end – especially as the next German government will probably adopt a tough tone on bailouts.
In light of the European economy’s momentum – growing at nearly twice its potential rate – and the tightness in credit spreads, only a relatively low amount of purchases is necessary at this time, in our view. This may push yields higher and spreads wider over the near term, but would prevent the ECB from becoming hamstrung in six to nine months’ time.
We believe this is why the central bank has placed so much emphasis on forward guidance and its plans for reinvesting its bond holdings. Policymakers may well be preparing the market for a smaller amount of net purchases – perhaps €20bn per month, for nine months. This would leave them with another year of potential buying and enable them to avoid hurting the economy today. Anything more aggressive could make the euro area vulnerable in the future.
Nicholas Wall is a global bond portfolio manager at Old Mutual Global Investors