ECB Watch - Will the heightened concern about fragmentation limit normalisation?
Our key takeaway is that the main challenge for the ECB in fighting fragmentation without changing the policy stance is scale. Both skewing reinvestments and a sterilised net purchase programme may struggle in terms of size. In this sense, at some point, the ECB may need to make choices between the extent of policy normalisation it would like to achieve and effectively fighting fragmentation. The fall in Bund yields on today’s news suggests investors are making the judgement that the ECB’s concern about fragmentation may reduce the degree of monetary tightening over the coming months.
Following the ad hoc ECB Governing Council meeting on the ‘current market situation’ the ECB decided that:- It will apply flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism- It will mandate the relevant Eurosystem Committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council Our key takeaway is that the main challenge for the ECB in fighting fragmentation without changing the policy stance is scale. Both skewing reinvestments and a sterilised net purchase programme may struggle in terms of size. In this sense, at some point, the ECB may need to make choices between the extent of policy normalisation it would like to achieve and effectively fighting fragmentation. The fall in Bund yields on today’s news suggests investors are making the judgement that the ECB’s concern about fragmentation may reduce the degree of monetary tightening over the coming months.
PEPP reinvestments
The Governing Council’s statement suggests that it will already start to skew reinvestments towards capping spreads, with likely a particular focus on Italy and Greece. However, the size of reinvestments – even assuming a significant skew towards peripheral sovereign bonds - means that this plan may not ultimately be successful.
New anti-fragmentation instrument
The new instrument will likely be a new asset purchase programme. As we noted in a note earlier today, a reasonable analogue might be the Securities Markets Programme, launched by the ECB in 2010 with the aim of capping spreads to ensure the transmission of its monetary policy. A look at the SMP provides five lessons about any new tool:
The SMP was employed when the 10y spreads of the bonds of the targeted jurisdictions were in excess of 300bp
The SMP was sterlised so that it had no impact on the monetary policy stance. This is a limitation on the size of the programme, because there are limits to how much of the liquidity can be absorbed. Overall under the SMP, around EUR 220 bn of bonds were acquired between 2010 and early 2012, which is quite modest compared to the peak periods for the PEPP and APP.
The bonds purchased under the SMP had senior status. This undermined the effectiveness of the programme. Subsequent programmes, including the OMT shifted to equal status and we think that is likely with any new tool.
The ECB did not announce detailed modalities on the SMP, in terms of maturities or size.
The SMP had a significant impact on spreads after announcement but it was ultimately unsuccessful. Hence it was replaced by the OMT, which probably was durably effective because markets speculated that QE would eventually come into place.