Super Mario. Sharing risks and gains in a new constellation.

The monetary order of the Eurozone is far from perfect, as we all know. But are historical changes going on? Will a new equilibrium between centralisation and decentralisation emerge? Read all about it!

from: Erwan Mahé

That’s it, they finally did it! The ECB President made a huge announcement yesterday the highlights of which are:

–      Programme size: €60 billion monthly, totalling €1,140 billion for the period from March 2015 to September 2016, at least, or until eurozone inflation reaches the ECB’s inflation target.

–      Inclusion of eurozone sovereign bonds in the programme, based on a capital key reflecting each nation’s contribution to the ECB’s capital.

–      Inclusion of debt of eurozone institutions (EIB, ESM, etc.) and agencies amounting to 12% of the additional asset purchases.

–      The ECB will organise the programme, although the national central banks will hold most assets on their own balance sheets.

–     Elimination of the 10-bps spread applied to the TLTRO

I will discuss more thoroughly each of these points below, because the devil is often in the details, but my first reaction is highly positive. As seemingly confirmed by the sharp hike in the Bund, the compression of the spreads on peripheral nation debt, the lowering of the euro and the surge on stockmarkets. Moreover, Mario Draghi has pulled off a very astute move, both in form and content, as I will explain below.

Where will the €60 billion go?

Mr Draghi’s decision to start off his statement with the announcement of a €60 billion figure was a brilliant stroke. In effect, the rumours were of a €50 billion monthly QE for a total of between €500 billion and €1 trillion, depending on the programme’s lifespan. The markets were therefore positively surprised on this point, although the reality is that the €60 billion figure includes the existing purchase programmes for asset-backed securities and covered bonds. These purchase programmes amount to about €12 billion per month, as of today! As such, this brings the additional purchases to €48 billion (60 -12 = 48), in another words, pretty much in line with market expectations of recent days.

The total amount to be purchased over the 19-month programme length (from March 2015 to September 2016) thus comes to €1,140 billion. If we add the €60 billion of covered bond and ABS purchases probably made by the beginning of March, that brings the overall amount to €1,200 billion! This should bolster strongly the credibility of the ECB’s drive to expand its balance sheet to the level of 2012, given that it is today €900 million below that figure.  According to the ECB press release, the eurozone agency debt purchases will amount to 12% of the additional asset purchases, which should equal €5.75 billion (12% X 48 = 5.75). That leaves €42.25 billion (48 – 5.75) for the purchase of sovereign bonds in the proper sense of the word. These are obviously approximative figures. The ABS and covered bond amounts may vary, if the ABS pick up on the primary market, as many hope.

To simplify, we will take the following figure as our guide:

Covered bonds + ABS          à €12 B

Eurozone agencies               à    €6 B

Sovereign bonds                  à  €42 B

Bear in mind that the €42 billion is lower than the 80% of risk that must be borne by the national central banks (€60 B X 80% = €48 B), which implies that  the NCBs (national central banks) will carry out the entirety of the sovereign bond purchases!

So how will the €42 billion in monthly asset purchases be shared from country to country?

Here is the link to the ECB press release that explains the share of each eurozone nation’s contribution to the ECB’s capital, based their economic weight on the eurozone: http://www.ecb.europa.eu/ecb/orga/capital/html/index.en.html.

Be advised that I recalculated the percentages in the ECB table, which account for 70% of ECB capital so as to include the remaining 30% held (but not paid up) by NCBs that are members of the Eurosystem but not the eurozone, like Denmark, Sweden and the UK, among others, which are not directly concerned by this programme. I present below the (rounded out) figures in euro billions, minus the countries whose total is less than €10 billion on the period:

Country                            Per Month         March 15 – Sep 16

Belgium	1.50	28
Germany	10.8	205
Ireland	0.7	13
Greece	1.2	23
Spain	5.3	101
France	8.9	168
Italy	7.4	140
The Netherlands	2.4	45
Austria	1.2	22
Portugal	1	22
Finland	0.8	14

This makes for a total of €482 billion for the core countries and €299 billion for the peripherals. I arbitrarily included France among the core countries, given its current 16-bps spread on the 10-year treasury bond with Germany, but you can adjust these categories as you deem warranted. Now, let’s examine the emblematic case of Italy in order to try and measure this programme’s impact on the bond markets of the countries concerned.

What is the impact on the peripherals?

On the basis our quick calculations, the Bank of Italy will have to buy about €90 billion of Italian sovereign debt during next year. BTP issues for 2015 are estimated at €268 billion gross and €62 billion net, after accounting for the €206 billion in reimbursements scheduled this year. This means that the new buyer, the Bank of Italy, has the totality of the country’s net issuance needs covered, representing  34% of gross issue volume. That is just enormous. It will remove any rollover risk on the debt for awhile. As a result, the risk premium on Italian debt should continue to contract. Today that premium still amounts to 110 bps on 10-year German debt. This reduction in the risk premium should also make itself felt on all risky asset classes such as stockmarkets.

We are also drawn to the case of Greece.

If we operate on the assumption that the new Greek government will act in sufficiently adept manner to become eligible for this asset purchase programme, the €15 billion or €20 billion considered represent almost half the Greek sovereign debt still on the market! Under these conditions, it is hard to imagine how the country will be able to use its share of the QE without  a massive skewing of the market pricing of the yields paid on its sovereign debt, given that the current market price required for the acquisition of Greek 10-year bond is 8%. In any case, this is why I am delighted that the NCBs are making these purchases instead of the ECB itself. It means that Greece has the most to gain from the seigniorage (carry trade) on its own debt when its central bank transfers the gains to the Greek treasury. In contrast, the Buba, which will have to content itself with the tiny interest rate income on its sovereign debt, stands to gain very little indeed. I must admit that I do not know how Germany will be able to buy so much of its national debt, given that net issues for 2015 are estimated at €15 billion! I was also frankly surprised by Mr Draghi’s statement that NCBs will be able to buy bonds at negative interest rates. Not only does that violate in no uncertain terms the (ridiculous, in times of deflation, but that’s another story) prohibition of public sector financing by a NCB, it also guarantees that the NCB in question will rack up a loss. On the other hand, I have long pointed out that there will  never be losses due to mark-to-market, because such purchases will be depreciated by the straight line method over their length of their term, based on their acquisition price.

Is a QE really limited in size?

The debate continues to rage on how to interpret the following sentence: The programme will encompass the asset-backed securities purchase programme (ABSPP) and the covered bond purchase programme (CBPP3), which were both launched late last year. Combined monthly purchases will amount to €60 billion. They are intended to be carried out until at least September 2016 and in any case until the Governing Council sees a sustained adjustment in the path of inflation that is consistent with its aim of achieving inflation rates below, but close to, 2% over the medium term. Some interpret this inflation target condition as a clever way of allowing the ECB to make an early exit from its QE, should, for example, inflation rebound strongly on rising oil prices by Q1 2016. According to this view, the ECB could then end its programme early, instead of waiting until September 2016.

While such caution is understandable, especially after the credibility shock inflicted by the Swiss National Bank last week, I think it makes more sense to view the clause in a diametrically opposed and much more positive way. Indeed, after repeatedly stating as of late that the ECB would find itself in a position of illegality if it did not fulfil its mandate (watch out for prison Mr Weidman!), it would appear that Mr Draghi finally dragged his opponents into an unstoppable mechanism. Imagine if inflation turns out to be still unacceptably low in September 2016 (although I think any such decision would be telegraphed way ahead of time). How could the ECB refuse to continue with a policy that never led to the risks (hyper-inflation, monetisation of the debt and a Weimar Republic situation) so feared by its fiercest opponents?

In this respect, this QE really is open-ended and solely dependent on the behaviour of eurozone inflation in the years to come. Maybe we will have to wait until all the public-sector debt ends up in the vaults of central banks before we realise that a QE is not, in and of itself, inflationist. Inflation depends on the relationship between supply and demand, the output gap and the relationship between prices and wages, and not the level of interest rates paid by governments for their debt!

And more good news!

The ECB President also declared that the securities acquired as part of this QE will be treated on a “parri passu” basis, and not have preferential status.That is the least we could expect, after the horrible way in which the Greek debt securities were handled during the default of 2012, but it was worth stating it in black and white. As a result, the other holders of this debt will not have to worry about taking an even bigger haircut, given the ECB’s presence on said debt (presence in their back, like during the Greek crisis in 2012). To wrap up, although there are still plenty of things to say on this exceptional event for the euro, the announcement of the end of the 10-bps  (0.10%) spread paid on lending to commercial banks via the TLTRO programme is also excellent news. This measure will contribute directly to the  building of a renewed cohesion of the European financial system by lowering the resource costs of commercial banks in the peripheral nations that continue to suffer from the  flight of deposits in 2010-2012. This will in turn help bring down short-term interest yields on the money market.

All in all, yesterday was a very good day for risky assets, which supports the bias we present below, but there remains question about the level of German rates. I thought a programme of this magnitude would have triggered a hike in inflation expectations and slammed the brakes on the Bund’s rise , especially if we excluded the possibility of buying debt at negative interest rates. It seems that such is not the case and that I will have to think a bit more about the implication on the Bund price, which is today totally cornered »…