ECB and BoE provide further easing but deep recession looks inevitable

Lagarde finds her bazooka

Following the disappointing reaction in financial markets to its previous meeting, the European Central Bank (ECB) decided to boost its stimulus package in an attempt to restore confidence in markets. ECB president Christine Lagarde’s comment that the central bank was “not here to close spreads” shocked investors and sparked a deeper sell-off in equity markets.

Also, and possibly more importantly, peripheral government bonds were also selling off (yields rising), raising the cost of financing for those governments and corporates, and raising the risk of a repeat of the sovereign debt crisis.

The emergency meeting late on 18 March of the ECB Governing Council led to the announcement of the new Pandemic Emergency Purchase Programme (PEPP) – a €750 billion (6.3% of GDP) scheme. The PEPP will fund the purchase of government and corporate bonds as per the existing asset purchase programme (APP), until the end of the COVID-19 crisis, but not before the end of 2020.

A special waiver of the eligibility of bonds has been granted to allow for the purchases of Greek government bonds, as they currently do not enjoy an investment grade rating. Presumably, this has also been done with one eye on the rating for Italian government bonds, with Italy precariously close to losing its investment grade rating.

The ECB is still not ready to abandon its self-imposed purchase limits (no more than a third of any bond issue), or deviate from the so-called capital key. The latter ensures the ECB is buying in proportion to the size of economies, and is not favouring any particular member state.

However, the ECB has suggested that it will consider making changes to these constraints, but is not ready to do so yet. It also pointed out that it has some flexibility in the near term to focus purchases on particular assets by class or jurisdiction, but ultimately, it would have to revert to the capital key by the end of the year.  

The ECB also expanded its corporate sector purchase programme (CSPP) to include non-financial commercial paper – short-term bonds with a maturity of under a year. This allows for greater lending to companies that may not have wanted to borrow for a longer period of time.

Overall from the ECB, the new €750 billion package is much more of the scale that is required to keep investors on side. Note, the PEPP is now added to the €120 billion announced at the last meeting, and the existing APP purchase of €20 billion per month. In total, this takes its quantitative easing programme from €60 billion per quarter to €350 billion per quarter.

However, until there is an explicit guarantee that the ECB is prepared to fully stand behind Italy in the event that a bail-out is required, then the risk of a debt crisis remains. Italy is far too large to bail out using the existing fund/programmes available. Italian bond yields have fallen (prices risen) since the announcement, but remain far higher than they were before the COVID-19 crisis began.

BoE – the return of QE

Though the Bank of England’s (BoE’s) last meeting had a more positive outcome than that of the ECB, it too has decided to announce new emergency measures after there was a rise in gilt yields, leading to a tightening of financial conditions.

The BoE decided to follow its previous cut in the main policy interest rate from 0.75% to 0.25% with a further cut to just 0.1%. To show the level of urgency, the BoE also announced it was restarting its QE programme, which had been dormant since 2016. The Bank has pledged to increase purchases by £200 billion to a total stock of £645 billion over an unspecified timeframe.

The Bank’s actions will help lower bond yields, along with borrowing costs for mortgage holders and commercial borrowers, therefore helping to reduce the likelihood of financial distress.  However, both its actions and that of the ECB will not stop the deep recession that is now expected. The shutdown and lockdown of entire countries is likely to cause the most severe recession since the 1930s.

More to come?

Looking ahead, we continue to expect the ECB to deliver one 10 basis point cut to its deposit rate, and could increase purchases further. As for the BoE, it is unlikely to cut the interest rate any further, but it could certainly increase QE.