News & analysis

Since the beginning of the coronavirus crisis, the European Central Bank has delivered a relatively rapid response to the economic challenges, mainly focusing on credit conditions. In addition to short-term liquidity measures, the bank increased the ongoing APP with an envelope of €120bn and launched the pandemic QE programme (PEPP) of €750bn for coronavirus-related loans.

It did this while signalling a wider flexibility in the composition and extension of bond purchases. There are estimates indicating that March purchases of Italian bonds nearly doubled the 17% allocation in the ECB´s capital key. However, without explicitly declaring specific tolerance limits to both issuance and capital key rules, markets lack clear information on the extent to which the ECB will exercise such flexibility. This means that, while the central bank still has ample room to support financing conditions in the euro area, the measures might be less effective in the short term without further clarification. The ECB still lags behind other major central banks like the Fed, BoJ or BoC, which have fully and vocally committed to support governments’ emergency expenditures and corporate financing needs.

Increasing spreads on public debt markets impose constraints for countries with a sensitive fiscal situation, crucially those worst hit by the coronavirus outbreak.

Although this is a common issue across Southern European states, Italy remains in special focus as the third largest economy in the euro area. The spread between 10-year Italian bond yields and the German equivalent has soared nearly 100 basis points since the spread of the coronavirus in mid-February. With a debt burden of 135% of GDP already by the end of 2019, the economy will experience an explosive debt dynamic, potentially curtailing Italy´s effort to overcome the crisis in the short run. This is ultimately relevant to the euro area as a whole, since the “abandonment” of Italy by dominant German fiscal decisions in the bloc may risk pushing the Mediterranean country towards populist politics and raise the risk of serious fissures within the eurozone or even an outright departure.

 

Increasing spreads across Southern European countries leave the ECB with additional tasks at hand

 

In our view, it is crucial for the ECB to move towards easing pressure on spreads in the area.

A likely action to address such unbalances would be to expand PEPP by some €250-500bn to serve as a backstop against increased fiscal issuance needs, especially in Southern Europe. An additional envelope of €500bn, used in conjunction with flexible implementation or relaxation of the capital key, would act as a backstop for Italian and Spanish issuance for 2020, while leaving room for purchases elsewhere. Although a large upsizing of PEPP would be effective, a decisive action to compress premium gaps would come in the form of extended and transparent flexibility to eligibility criteria for the purchases. Additionally, the bank could continue to support credit conditions via the TLTRO program to spur more targeted lending. In Thursday’s meeting, investors will also focus on the Governing Council’s views on the economic outlook amid the increased economic uncertainty.

In theory…

Fresh QE announcements would normally weigh on the currency because of the expanded monetary base and the “lower for longer” signalled rates, under which investors are encouraged to take higher risks on higher yielding foreign assets. However, policies aimed at channelling credit to the real economy and at reducing sovereign spreads could actually induce some currency appreciation by reducing domestic risks.

Ultimately, the path for the euro in the near term will depend on the mix of measures introduced and the commitment of the ECB to make up for the lack of political will in the area to mutualise risks. A “wait and see” approach, if taken by the ECB, will likely deepen the inertial widening of yield gaps, forcing a weaker euro as a result. Alternatively, more targeted credit action, via TLTROs or more flexible QE, could strengthen the currency along with shorter spreads. Finally, even a more sizeable easing program would likely still be euro-positive under present conditions as it can meaningfully reduce issuance concerns across the area.

 

Worst hit countries face an increasingly weak fiscal situation amid the coronavirus crisis

Note: The size of the bubble represents the expected Debt-to-GDP ratio by the end of 2020. The colour represents the S&P-equivalent rating outlook: Blue, stable; Orange, negative. Figures In the labels represent the expected deficit and debt as percentage of GDP respectively by the end of the year.

 

 

Author: Olivia Alvarez Mendez, FX Market Analyst

 

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