Confidence in the Euro Yield Curve

Thursday’s ECB meeting left us in little doubt that we should expect some serious action in December, including the possibility of some new, as yet unused measures.

While we can speculate what these might be, one thing we can be pretty sure of is that the Pandemic Emergency Purchase Plan (PEPP) is likely to be increased from its current €1.35tr. PEPP was initially launched in March with €750bn and then topped up in June by another €600bn, so it is easy to see its firepower being increased to nearer €2tr at the ECB’s December meeting.

These very large numbers must be put into context, and given the funds will be largely targeted at Eurozone government bonds, we should look at the size of the programme relative to the likely surge of issuance in this market. Who is going to finance governments’ ballooning deficits and subsequent debt mountains? According to research from Citi, we can expect around €1.2tr of Eurozone government bond supply in 2021, however with coupon payments and maturities, this translates into net issuance of just over €400bn. Even without an increase in the PEPP, the ECB is projected to be buying more than net supply, with the biggest beneficiary being Italian BTPs. A big increase in the PEPP could result in the ECB buying close to double the net supply of Eurozone government bonds in 2021. Personally I think this would be a bit of a waste of the central bank’s firepower, and I would prefer it to be used in promoting lower rated credits into the wider market, but it is clear to me that the technical picture created by the central bank will overwhelm the wall of pandemic induced supply.

Our takeaway from this is not a green light to buy Eurozone government bond debt (though a reasonable case can be made for BTPs, where the spread to Bunds has been contracting rapidly), but to have confidence in the yield curve. Yields in Eurozone government bonds are heavily underpinned, which means we think investors can buy corporate debt with confidence in euros (hedged of course) even at longer maturities, which is important as we expect corporate spreads to narrow over the medium term. Maybe the same cannot be said about the US yield curve, where the case for longer dated Treasuries is at least more balanced, with a skew to moderately higher yields. This is further supported by the increasingly large difference in inflation rates between the Eurozone and the US.

Our second takeaway from Thursday’s ECB meeting was that the central bank is concerned at the tightening of monetary conditions caused by the commercial banks, as shown in the ECB’s latest Bank Lending Survey. This of course tends to happen in every recession, and it is part of the ECB’s job to neutralise this with its policies. The ECB essentially wants lower credit costs for as much of the economy as possible, which from a fixed income investor’s standpoint means tighter credit spreads. This is perhaps more pressing than the government bond supply issue addressed above.

So what do we expect? The obvious candidate is another Targeted Long Term Repo at a discount to the Refinancing Rate, so it is profitable for the banks, but if we have a month of difficult financial markets before then, it is quite possible that we see the introduction of new measures to help drive down credit costs.

Either way, December’s governing council meeting could be Christine Lagarde’s most interesting to date.