3 Things the European Investment Grade Fixed Income Team Talked About Last Week

1. Forthcoming ECB Meeting – What Might Happen?

The ECB approach their meeting this week in a good position. Recent data has shown that, so far, the impact of Brexit on European economic activity has been minimal, with August Purchasing Manager Indices (PMI’s) holding around the average for 2016. So no pressure for immediate or significant action. What will concern the ECB is the recent inflation data, which showed minimal pick-up at the headline level, whilst the core rate actually fell on an annualised basis. The September 2016 meeting has long been seen by market commentators as the meeting at which the ECB will announce an extension and/or enhancements to their Quantitative Easing (QE) programme, but some are now speculating that any announcement will be postponed until the December meeting. With purchase under the QE programme surpassing €1trn on September 1 ^st , investors remain concerned that the ECB will run out of bonds to buy. Here we rank the options available to the ECB, ranking from most unlikely to most likely:

• Buying senior bank corporate bonds: unlikely to happen in our opinion, as it would the ECB in the tricky position of buying senior debt in entities that it regulates.
• Changing the purchase allocation from current “capital key” method to “market-capitalisation” basis: we believe this is unlikely to occur, as the Bundesbank have been vociferous in their comments that market-capitalisation based buying is akin to monetary financing.
• Cutting the deposit rate:- the ECB have mentioned on more than one occasion that they are cognisant of the effect of negative deposit rates on banks’ profitability. Therefore, we believe that any significant cut in the deposit rate is unlikely, although a token 10bps cut could be an option.
• Extend the maximum maturity limit from current 30 years to 50 years: given the demand for yield from investors recently, many Euro-area debt management offices have issued 50-year debt, which is currently not eligible for buying by the ECB. Extending the maturity limit would increase the eligible pool by €100bn, but not make a material difference.
• Changing the issue and issuer limit from 33% to 50%: the maximum share of any single issuer (without collective action clauses) that the ECB can hold has already been increased from 25% to 33%. This limit could be increased to something like 50% and would be uncontroversial, although of limited value. When first initiating the ECB programme, the ECB pledged not to buy any bonds that yielded below the deposit rate. That means not buying bonds below -0.40%. But with two thirds of German yields mow ineligible as they yield less than -0.40%, relaxation of this limit would be an easy win for the ECB. 26% or €1.6trn of all Euro sovereign bonds yield less than -0.40%.
• Increasing the programme size: current purchases are set at €80bn per month, and could be increased by another €10bn to €90bn. Again, a relatively uncontroversial move, but one that would most likely need to be combined with other actions to avoid a bond-scarcity issue.
• Simple extension of the programme by 6 months to September 2017. Pretty much expected by most market participants, as to not increase the programme duration could constitute a form of monetary tightening, and probably spark a big rise in bond yields, which the ECB definitely would want to avoid.

1. Volatility – There May be Trouble Ahead?

Summer 2016, and August in particular, was a particularly quiet periods in markets, compared to the surprise Chinese devaluation last year and the Taper Tantrum of 2013. The 10-year U.S. Treasury bond yield traded in a 10bps range between a yield of 1.50% and 1.60% for the month, whilst 10-year German Bunds had a similar trading range between -0.03% and -0.12%. Another measure of tracking bond volatility is the MOVE index (Merrill Lynch Option Volatility Estimate), and it’s currently at its lowest levels in over 18 months. Neither is the lack of volatility confined to fixed income markets – currency markets have also traded in tight ranges with Euro/U.S. Dollar having traded in a range between 1.10 and 1.14 since the start of March. Even the weaker-than-expected U.S. non-farm payrolls last week didn’t spark any breakout from recent ranges in either fixed income markets or currency markets. As noted above, this lack of volatility can be put down to a typical holiday period lull. But it can also be seen as a direct result of the power that central banks now have in influencing asset prices – their actions are now arguably more important than the underlying economic fundamentals in driving markets. September is shaping up to be a busy month for central banks, and therefore by extension for asset markets. The ECB, the Bank of Japan and the U.S. Federal Reserve all meet in September, with different expectations for different central banks. That, in turn, might lead to a recovery in volatility and some breaks in recent trading ranges.

1. Ireland – the Apple in the EU’s Eye

The headline was expected – “Apple faces penalty over Irish taxes”, but the detail was startling and completely unexpected. The European Commission ordered Apple to pay €13bn tax penalties after ruling that the Company’s Irish tax scheme was unlawful. The size of the penalty is at the extreme end of expectations – privately Irish government ministers were briefing journalists that they expected any penalty to be in the region “of hundreds of millions” rather than billions of Euros. “Thirteen billion Euros changes everything” was the quote from a senior minister of the ruling government party. You might think that this would be good news for a country that has experienced significant tax increases and austerity since its EU bail-out in 2010, so why is the Irish government so reluctant to collect the back taxes and planning to appeal the verdict? For a start, it raises the issue of sovereignty – who is responsible for setting a country’s tax and fiscal policies? With monetary policy already controlled by the ECB, fiscal policy is the only other option left to national governments to help them control their economy. Anti-EU campaigners across Europe were quick to point to this judgement as evidence of Brussels interfering in local politics, others were pointing to the necessity of having a level playing field across Europe in terms of corporate taxation policies. Which leads to the second point – Ireland has long defended its 12.5% corporate tax rate, which makes it a very attractive location for large, profitable multi-national companies. Other countries have long complained about this low tax rate, arguing that it gives Ireland an unfair advantage in attracting inward investment. The market implications cannot be ignored either – were the Irish government to use the €13bn to pay down existing debt, it would lead to a significant decrease in Ireland’s debt/GDP ratio and upward pressure on Ireland’s sovereign debt ratings. That in turn would argue for lower Irish government bond yields and tighter spreads against German government bonds. Alternatively, the Irish government could treat the potential windfall as a one-off relaxation of fiscal policy and use the proceeds to boost infrastructure spending (build new hospitals, universities, upgrade the road and rail networks etc.), which would have a positive knock-on effect on economic activity and the budget deficit. And isn’t this what many economic commentators are now arguing is now needed globally – a big fiscal stimulus programme to offset increasingly ineffective monetary policies?

So lots to consider for the ECB as they return from their summer holidays.