Eurozone: Deflation and weak activity support QE

December HICP inflation came in at -0.2% y/y, entering negative territory for the first time since October 2009. It was led by weak energy prices, which declined by 6.3% y/y. We now think that EA inflation is likely to remain negative for few more months, before the effect of a weaker euro kicks in. In this context, inflation expectations continued sliding and the 5y5y forward breakeven swaps dropped further to 1.5%. Data on economic activity came in mixed, showing that the euro area economy is not decisively moving away from zero growth.

November industrial production in Germany was somewhat weaker than expected, although underlying manufacturing data were up, but French IP printed negative again, highlighting the temporary nature of the Q3 GDP rebound (+0.3% q/q). The EA final composite PMIs were revised down slightly from the flash estimate to 51.4, leaving our Q4 PMI-based GDP indicator unchanged at +0.1% q/q, in line with our growth forecast. Meanwhile, euro area retail sales were stronger than expected in December, at 0.6% m/m versus c.f. 0.2% m/m, and December euro area consumer confidence remained stable at -10.9.

In an interview earlier this week with German newspaper Handelsblatt, ECB president Draghi confirmed that the central bank was stepping up for a QE programme, noting that “the risks of not fulfilling (the ECB’s) mandate of price stability are … higher than they were six months ago”. He said the ECB was working on technical preparations to “alter the size, speed and composition” of current asset purchase programmes. A similar message was delivered yesterday in a letter by Draghi to EU parliamentarians. These dovish comments pushed the euro lower, dropping below 1.18, the weakest euro since June 2010, and have reinforced the market consensus for an announcement by the ECB on QE. We expect the announcement to be made in two weeks’ time, at its 22 January meeting. There are however three important issues for the design of sovereign bond purchases by the ECB.

First, next week on 14 January, the EU court’s Advocate General will issue his opinion on the legality of OMT and the ECJ often follows the views of his Advocate General. A final ruling, however, may take a few more months. The key issue of “seniority”, ie, whether private creditors would be subordinated to ECB claims on member state debt, is likely to be addressed by the Advocate General. EU judges could theoretically reject the views of the German court that the ECB cannot promise pari passu treatment with other creditors in the case of haircuts on its public bond holdings. In our view, if the ECJ were to support the German court’s view of “seniority treatment” for ECB holdings of EGBs under the OMT programme, such a decision would severely limit the effectiveness of a sovereign-bond-based QE programme.
Second, markets are preoccupied with the issue of mutualisation of risks under an EGB-based QE programme. For QE to be effective, we believe it would need to include all countries’ EGBs and any potential losses derived from the purchases should be shared by all the NCBs. If instead the programme were to be based exclusively on AAA-rated bonds or, even worse, the potential losses (including default) of any given member state debt were to accrue exclusively to the corresponding NCB, then we believe the problem of market fragmentation and impairment to the monetary transmission mechanism would not be resolved.

Third, the victory of radical-left Syriza in Greece is likely to be a concern for ECB’s decision to purchase GGBs. As in the case of the ABSPP and CB3PP, we would expect that the ECB would require Greece (and Cyprus, both non investment grade) to be in good standing under a EU-IMF programme for them to qualify for QE. If the ECB: 1) announces QE on 22 January; 2) then releases the technical details of the programme on the following meeting on March; and 3) starts with actual EGB purchases shortly after, eg, by April, by that time the uncertainty about Greek politics is likely to have been resolved. Should a potential Syriza-led government reject a troika programme and propose a unilateral sovereign debt restructuring, we believe GGBs would almost certainly then be excluded from QE.

In sum, we do not think that these legal proceedings will unduly delay an ECB government bond purchase programme. Without a final ruling by the ECJ, however, the ECB might avoid certain language (such that interventions could be “unlimited”), and may also be reluctant to purchase government bonds that explicitly contain collective action clauses, or to purchase any GGBs until there is clarity of Greece’s standing on a troika programme. Evidently, size matters for QE; our view is that the most effective form of QE would be an open-ended programme, with declared monthly purchases until a given inflation threshold is met.

However, we expect that the announcement on 22 January would be less ambitious, and may signal again that the target is to increase the balance sheet by EUR1trn and that EGBs would contribute to that, along with the TLTROs, ABS and CBs. The market appears to be less optimistic about the impact that EGB purchases could have on the inflation and growth outlook in the EA. While it appears to be market consensus on the likelihood of EGB-QE being launched imminently, there also seems to be consensus on the inability of QE to make a fundamental macroeconomic difference.

The increasing political risks in the EA in 2015 (Greece, Spain, Portugal, and France) make the support of the EA economy through QE all the more important. However, reliance on QE alone as a remedy to improve the EA outlook would in all likelihood disappoint the markets and could reverse the very tight spreads that periphery debt has enjoyed thanks to the ECB threat to launch QE. A significant widening of sovereign spreads post QE could potentially change investors’ perception on sovereign solvency in the current scenario of very low nominal GDP growth and very high levels of public debt.

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