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To the European Central Bank President Christine Lagarde’s relief actions did speak louder than words. The question for investors is whether more action is in store this week.
ECB policy makers, who will hold a virtual policy meeting on Thursday, have taken a number of emergency measures since their last meeting in early March, including a €750 billion ($812.5 billion) Pandemic Emergency Purchase Program.
The move puts the ECB on track to buy a total of €1.1 trillion in net assets this year. The central bank has moved to shore up lending by banks to businesses. Borrowing by businesses surged in March, according to the ECB’s latest lending survey, while household demand for loans dropped sharply, in keeping with the massive hit to economic growth from coronavirus lockdowns.
Those moves came less than a week after Lagarde’s clumsy response in early March to questions about turmoil in Italy’s government bond market when Lagarde said it wasn’t the bank’s job to “close spreads” as Italy’s government bond yields soared relative to German yields. Lagarde attempted to walk back the remarks almost immediately.
“Christine Lagarde’s faux pas on yield spreads and the (no personal) need for ‘whatever it takes’ added some bruises to the ECB’s reputation as almighty crisis manager,” said Carsten Brzeski, chief eurozone economist at ING, in a note. “The measures taken since the March meeting have restored this reputation.”
While the ECB stepped up action, eurozone politicians have yet to agree on a coordinated fiscal plan, leaving the central bank in its familiar role as the “only game in town.”
But does the ECB need to do more? Some analysts look for the ECB to follow the lead of the Federal Reserve and indicate it’s willing to buy junk-rated corporate bonds. It’s already taken a step in that direction, agreeing last week to allow banks to use future “fallen angels” — investment grade debt that’s slips into junk status — as collateral. Some also look for a boost to the overall size of the asset purchases, noting concerns about a renewed rise in yields for Italian government bonds.
Fitch Ratings on Wednesday cut its rating on Italian government debt by one notch to BBB-, just one rung above junk. S&P Global Ratings last week left Italy’s rating unchanged two rungs above junk.
Italian government bond yields TMBMKIT-10Y, 1.788% rose in the wake of the Fitch downgrade, raising the yield premium demanded by investors to hold Italy’s bonds over German debt TMBMKDE-10Y, -0.528% by around 4.6 basis points to more than 2.25 percentage points. The spread, however, remains well off its mid-March high around 3.18 percentage points.
The euro EURUSD, -0.00% has fallen around 1.7% versus the U.S. dollar in April, after a volatile March that saw it spike versus the greenback and then retreat sharply amid a global rush for dollars as companies and banks drew down credit lines. The Fed and other major central banks, including the ECB, responded by expanding swap lines and taking other steps to ease the dollar crunch.
On the junk-bond front, analysts at Jefferies argued that the ECB’s decision to grandfather in fallen angels, specifically government and corporate debt that was considered investment grade in March, doesn’t open the door to buying corporate junk bonds as part of its asset purchase program. The ECB’s announcement “in a sense clearly separates the assets the ECB is and is not prepared to buy at the moment,” they said.
“Undoubtedly, Lagarde will stress that the ECB can change its mind but as with adding bank bonds into the mix of eligible assets to purchase, for the Governing Council this would likely be part of a deeper review of what support it may need to provide to the economy later in the year,” they said.
What about expanding the program? Economists Nick Kounis and Aline Schuiling at ABN Amro expect the ECB to increase the PEPP program by €500 billion.
“A key way the ECB is trying to arrest the tightening of financial conditions is by making sure that risk-free rates and country spreads do not rise significantly. Yet a surge in bond supply is complicating that task and we think the ECB will step up purchases in order to absorb the additional issuance by sovereigns,” they said.
Others aren’t convinced the ECB needs to act right away.
The ECB’s main concern, said ING’s Brzeski, is ensuring that a vicious circle between rising government bond yields and eurozone banks, particularly in Italy, doesn’t arise. Rising yields and falling bond prices damage bank balance sheets, sparking fears of a bailout, which in turn contributes to fears over government debt. That explains last week’s move to include fallen angels as eligible collateral — a move that comes amid fears Italian government debt could face a downgrade into junk status.
It would make sense for the ECB to hold off on expanding its program, perhaps to June when revised staff projections are due, Brzeski said. At that time, the ECB could take the further step of making fallen angels eligible for its purchases program and even consider buying bank bonds.
That brings the focus back to communication. “A strong and convincing message from Lagarde on Thursday could therefore save the ECB from taking even bolder steps, at least for now,” Brzeski said.
