A year after the European Central Bank (ECB) unveiled its first quantitative easing (QE) program, Eurozone markets are preparing for another potential wave of stimulus. The Eurozone continues to struggle with inflation well below its target of just under 2%, and the ECB is widely expected to cut its 2016 economic forecasts again. Judging by ECB President Mario Draghi’s recent statements, the December 3rd meeting is likely to bring further policy action, and the ECB staff is in “work and assess” mode on the possible measures. We see a range of policy options for the ECB, as outlined below in order of which we think are most likely. Our base case is for the ECB to announce an expansion of QE, and a cut in the deposit rate.
As for the market impact, in the near term we see pressure on the euro to weaken and Eurozone rates delving back into negative territory. The upshot for global markets is yet another round in the hunt for yield that has benefited riskier assets in the past few years of near-zero interest rates. We also see some market uncertainty as investors contemplate the ECB’s plans alongside expectations of a potential rate hike by the US Federal Reserve.
On December 3, we think the ECB is most likely to:
â– Expand QE. We think the ECB will probably announce two key changes to the current asset purchase program:
1. Increase the pace. Our base case is for the ECB to raise the amount of monthly sovereign bond purchases from the current €60bn to €70bn.
2. Extend the projected run. We expect the ECB to postpone the QE program’s review by around six months, from the current September 2016 to the first quarter 2017.
■Cut the deposit rate. President Draghi’s recent comments provided a rationale for a further cut to the deposit rate, which the ECB previously said would go no lower than the current -20bps. Asked in the October meeting about risks to the bank’s credibility if the ECB cuts the rate again, Draghi observed that a central bank’s credibility depends on its ability to achieve its primary mandate—in the ECB’s case, inflation just below 2%. We think a cut to -30bps is likely.
Less likely moves, in our view:
â– Expand range of asset purchases. The ECB may also choose to diversify its purchases to include:
1. More asset-backed securities. The ECB was buying asset-backed and covered bonds in October 2014, before the announcement of full-scale QE in January this year. Increasing purchases of these instruments is an option, but limited given that the current volume of purchases is already a substantial portion of the market.
2. Corporate bonds. While we think the chances of adding corporate bonds to the ECB’s eligible purchases have risen, we believe policymakers will stop short of this measure in December. We see three main hurdles, as 1) we believe the ECB remains reluctant to assume more credit risk, 2) the corporate credit market in the Eurozone is small and illiquid relative to the sovereign markets and 3) such policy will be difficult to implement equally across Eurozone markets, since they vary greatly in size.
3. Equities. We think risk aversion will also prevent the ECB from expanding its purchases to equities at this stage.
Three takeaways for investors
■Euro pressure is likely. We expect that a deposit rate cut may weigh on the euro in the short run. Over the longer term, however, we think the Eurozone’s large current account surplus probably limits the common currency’s downside.
â– Eurozone rates are likely to outperform the US. We anticipate further divergence in these markets, with the US underperforming as US rates rise to price in a higher likelihood of a December rate hike.
Peripheral Europe could benefit. Looser monetary policy in Europe could, in our view, benefit some peripheral debt issuers. Our view is based on the revived grasp for yield as core Eurozone rates are pressured lower. In particular, we see potential for rallies in Italian sovereign bonds given our expectation of light supply for the remainder of the year.
