ECB Upgrades Economic Outlook
The European Central Bank (ECB) has expressed confidence on the positive effects of quantitative easing, resulting in upbeat growth and inflation forecasts. With bond purchases starting, a mismatch between ECB demand and bond supply could cause constraints regarding potential program extensions.
While the ECB left monetary policy unchanged at the March 5th meeting as expected, market participants eagerly awaited the new economic forecasts by the ECB staff as well as further details regarding the quantitative easing (QE) program.
Upbeat ECB growth and inflation forecasts
Compared to the December economic forecasts, the ECB staff revised GDP growth for the Eurozone significantly higher to 1.5 percent for 2015 and 1.9 percent for 2016 (from 1.0 percent and 1.5 percent, respectively). These forecasts are slightly higher than our current values, but seem fairly plausible to us as momentum in the Eurozone is clearly improving. In its first projection for 2017, the ECB estimates that growth will actually accelerate to 2.1 percent. These upbeat moves illustrate the ECB's confidence that QE will provide an important boost to the Eurozone economy. On inflation, the downward revision to 0 percent for 2015 came as no surprise, as the ECB had previously underestimated the impact of the oil price decline. However, the ECB expects inflation to gradually move toward its target in 2016 and 2017 (forecasts are at 1.5 percent and 1.8 percent, respectively). The ECB forecasts look consistent with QE lasting until September 2016 (which is the minimum duration mentioned initially) and a subsequent period of "tapering". ECB President Mario Draghi emphasized the open-ended nature of the program, meaning that QE will be conducted until inflation sustainably moves back toward the ECB's target.
Government bond purchases start soon
The ECB also revealed further details of the QE program announced in January (see box) and will start buying government bonds on 9 March. The exact amount remains unclear, as the ECB only set a target for the total of monthly asset purchases (60 billion Euros) which will include asset backed securities (ABS) and covered bonds. Taking into account the past pace of purchases of those assets, we estimate the ECB will have to buy around EUR 45 billion of government bonds per month. Purchases are allocated across countries according to the capital key (see box), which implies that three quarters of all bond purchases will occur in the "big four" markets, namely Germany (25.6 percent), France (20.1 percent), Italy (17.5 percent) and Spain (12.6 percent).
Mismatch between ECB demand and bond supply
This allocation rule entails a considerable mismatch between ECB purchases and actual bond supplies (see chart), with Germany standing out, in particular. If we assume the program will run until the end of 2016, the ECB would have to buy around 200 billion Euros of German government bonds (Bunds). At the same time, the actual supply of Bunds is expected to shrink, as Germany is likely to generate budget surpluses in 2015 and 2016. Even though the stock of German bonds is, in principle, sufficiently large at 1.2 trillion Euros, the ECB will depend to a large degree on the willingness of investors to sell their Bunds. Some market participants believe it might all come down to aggressive pricing on bonds where supply is scarce. Indeed, the ECB noted that it is also willing to buy bonds with negative yields. This will tend to push investors into securities where supply is ample, such as peripheral or French bonds. In this scenario, yields would likely remain artificially low across the board.
Support for economies, also via weaker euro
Despite the differences in scarcity, we believe that it basically does not matter which bonds the ECB actually buys, as all Eurozone government bonds will benefit from the fact that there is a "strong buyer" injecting considerable liquidity into the market. Spreads between German and peripheral bonds (Greece aside) are therefore likely to remain tight, or narrow even further, which should provide considerable support, not least for peripheral economies. Insofar as QE were to weaken the euro further, support will be amplified.
Limited bond supply constrains potential program extension
Interestingly, the ECB did not specify how it would treat government bonds from countries which have "insufficient" debt. If the capital key were strictly applied, the 25 percent issue limit (see box) would e.g. be reached within the next 21 months in all Baltic countries, as well as in Luxembourg and Slovakia (see chart). The weight of those countries in the QE program is, however, minimal. If the ECB wants to stick to the limit on its holdings, the single most constricting factor for the duration of QE will be Germany, as the biggest economy. According to our calculations, the ECB would already hold 22 percent of total German bonds outstanding by the end of 2016, thereby likely running into supply difficulties if it wanted to extend the program beyond 2016.