Rates Spark: the (QE) plot thickens

The shockwaves from yesterday’s German constitutional court (BverfG) ruling are likely to be felt throughout EUR financial markets for a while. Essentially, the court upheld the ECB’s PSPP but gave it 3 months to demonstrate it does not overstep its monetary policy mandate. We see three main avenues for the ECB and the Bundesbank to placate the BverfG:

• A further argument demonstrating that the ECB did indeed consider the economic implications of the programme. It may seem obvious to market participants that the ECB has but the court’s decision suggests it might not be easily swayed. In addition, our German economist thinks proportionality will be hard to demonstrate compared to what the economy would have been without those measures.
• A reaffirmation of the existing PSPP limits (holding limit of 33%, capital key allocation of purchases between countries, rating limits). We struggle to see what would be new here except for making these constrains more binding (such as by reducing capital key divergence). This could prove an operational constraint to PSPP, and almost inevitably prime PEPP for a similar legal challenge.
• A fixed horizon for PSPP holdings. Here too the problem it would pose to QE implementation is daunting.

Assigning a probability of each of these responses (or to another one not covered here) is probably best left to legal experts, especially since these are not necessarily mutually exclusive. There is a trend emerging however: the second and third, as well as any additional constraint, would weaken the credibility of the ECB’s crisis-fighting apparatus.

As we wrote in yesterday’s Spark, it is true that the court’s jurisdiction does not extend beyond Germany, but the ruling could prove a major political and operational headache. We assume here that the ECB will accommodate the court’s concerns, possibly by altering PSPP’s design. We thus think speculating about what would the ECB do in 3 months’ time, should the court clip PSPP’s wings, is not the best use of one's time.

A better use is trying to imagine what ECB intervention (PEPP included if it wants to avoid future challenges) would look like should it abide strictly to existing limits. Given the current pace of purchases, it is virtually impossible for both issue share limit and the capital key to both be observed for major countries, nor is it desirable. The upshot here would be that markets need to price a less aggressive ECB balance sheet expansion than currently.

This would not affect each bond market equally. The loss of ECB support would be aggravated by the flight of investors that bought Italian bonds thanks to QE. Add to this that the central bank’s programmes were a key reason for rating agencies to take a more lenient view on Italy’s credit. Clearly it is too early for them to review their decision, but now is not a good time to instil doubts about the ECB’s ability to carry out QE. Indeed, we read the ECB's statement issued last night, repeating it will continue pursuing its price stability objective, as an attempt to ease those doubts.

Core yields and swap rates would benefit from portfolio reallocation away from riskier bonds, and from dimmer economic prospects without ECB intervention. German bonds in particular would see reallocation flow partially offset the prospect of less central bank buying. Whether the net effect is higher or lower yields than currently is an open question. The extent of capital key divergence of late suggests that core yields are pricing less ECB support than the periphery. We would thus opt for lower rates.

Legal twists surrounding the BverfG’s ruling aside, attention should be squarely on issuance. Germany is conducting both a 5Y auction and a 15Y syndication today. This should put upward pressure on yields ahead of similarly heavy issuance slates from Spain and France tomorrow. Italy also announced it will add €1bn to 6Y and 8Y bonds today. Should risk appetite weaken further, supply would impact spreads more than base rates.

Single-digit PMI services readings in Europe would normally take centre stage but we doubt markets will pay much attention. The focus remains squarely on how developed countries unwind lockdown measures, with Trump pushing for a reopening 'soon'.