Rome May Be Burning, But Draghi Is No Longer Your Fireman: What To Expect From The ECB

Like Jerome Powell, Mario Draghi is sorry – not sorry.

Or actually that’s not fair. He’s probably a bit more sympathetic to the possible consequences of his actions than Powell. But not enough to discourage his colleagues from tipping that the discussion of winding down QE is still very much in play despite the fact that Rome is burning.

Comments out of ECB officials last week suggest the Governing Council is not inclined to view the Q1 deceleration in Eurozone economic activity as reason to postpone the discussion of APP wind down and, perhaps more importantly in the near-term, it doesn’t appear the Italian “problem” is sufficient to force an ECB relent either.

As a reminder, the ECB is effectively the only net buyer of Italian sovereign debt and there’s no question that CSPP has helped buoy Italian credit both directly and, more to the point for Italian HY, indirectly by driving investors down the quality ladder in search of yield.

Hilariously, some 90% of Italian credit now trades inside of similar maturity BTPs which, even after the recent bloodbath, I’d still argue are incredibly rich given the dour fiscal outlook and the inevitability of Five Star and League clashing with Brussels.

In other words, this is like absurdity squared or absurdity cubed – Italian credit is trading rich to Italian govies which are themselves rich to fiscal reality even after a horrific selloff and the reason everything is mispriced in the first place is because of PSPP and CSPP which represent “whatever it takes” taken to its logical extreme, itself a weird statement to make because what does “whatever it takes” even mean if not that something will be taken to its logical extreme?

In May, there was understandably a lot of focus on what the ECB bought and didn’t buy given the blowout in the BTP-Bund spread. For those interested, here’s the quick (and straightforward) take from BNP:

The key focus in May’s data fell on deviations versus the capital key, with Germany’s monthly net purchases coming in 5.3% above the capital key, the highest reading since the start of QE. Meanwhile, monthly net purchases in Italy and France came in 1.5% and 1.7%, respectively, below the capital key, ending months of deviation above the capital key (Chart 3). The absolute changes in monthly net purchases were revealing and suggested that the aforementioned dislocations versus the capital key were likely caused by some of April’s PSPP reinvestments in Germany being carried over to May. The monthly net purchase amounted to EUR 6.9bn in Germany, much higher than the EUR 4.8bn/month average in January-April this year. Meanwhile, in Italy and France the monthly net purchases amounted to EUR 3.6bn and EUR 4.2bn, respectively, broadly in line with the average EUR 3.6bn/month and EUR 4.1bn/month so far this year. Marginally slower monthly net purchase in Italy versus April (EUR 3.6bn in May versus EUR 3.97bn in April) could have been due to liquidity conditions.

As noted on Friday afternoon, this situation is the furthest thing from “fixed”. Italian equities have fallen for five straight weeks, Italian financials are a mess, the blowout in Italy CDS is spilling over into € financial spreads and the BTP-Bund spread is widening back out as technical tightening pressure from German yields repricing higher last week alongside the hawkish ECB rhetoric was more than offset by a back up in Italian yields.

More broadly though, we’re not back to 2011 quite yet. As BofAML detailed last week, this time is indeed different – so far, the situation hasn’t spilled over to the extent it did during the eurozone debt crisis. Here’s a handy set of charts (more here):

“Despite Italy’s stresses, contagion has been fairly limited,” Deutsche Bank wrote in a note dated Friday, before illustrating the point as follows:

For instance, the GDP- weighted 5Y government bond spread to eonia (excluding Italy and Germany) is only a few bps off its historical lows, more than 35bp below the levels ahead of the French election and more than 300bp away from the levels observed in 2011.

Still, there are any number of aggravating factors. For instance, compounding the complexity is the threat of tariffs and Trump’s increasingly shrill rhetoric towards Europe. In addition to refusing to extend waivers for U.S. allies on the metal tariffs, he reportedly told Emmanuel Macron that he intends to rid 5th Avenue of Mercedes before it’s all said and done.

Meanwhile, playing out in the background is the policy divergence story, which has reasserted itself with a vengeance in 2018 after giving way to a euro-positive policy convergence narrative last year.

“The ECB will not be derailed by Italy as long as there is no ‘unwarranted tightening of financial conditions’, i.e. no noticeable contagion,” Deutsche writes, in the same noted cited above. The bank also calls last week’s hawkish rhetoric from “the usually reliable ‘ECB sources’, Weidmann, Knot and crucially Praet'” the closest thing to “confirmation” that one can get in terms of whether “a decision on the APP may be forthcoming next week.”

On the macro front, Q1 was of course disappointing and that was reflected in the euro, where long positions were caught offsides as rate differentials continued to move back in favor of the dollar which finally began to respond after ignoring the shift initially thanks to jitters about the twin deficit issue in the U.S. and worries about what Trump’s trade policy says about the administration’s desire for a weaker greenback.

As documented almost everywhere you care to look, some of the deceleration could represent the eurozone running up against capacity constraints and irrespective of what the cause is and whether the weakness is indeed “transitory” (as the ECB generally maintains) or something more insidious and enduring, it’s now or never for normalization. If they don’t start replenishing the ammo then they run the risk of the dreaded “quantitative failure” and being forced to plunge even further down the extraordinary policy rabbit hole.

For their part, Barclays thinks they’ll put off an announcement until next month:

Now the ECB is ready to discuss the next steps, as Peter Praet clearly signalled this week. At next week’s meeting, the GC will discuss the options for tapering the net asset purchase programme towards zero. However, we do not expect policy changes in June; instead, we expect the tapering of QE to be announced in July (even if an announcement in June would not be a complete surprise to us). We think the GC will feel no urgency to take a final decision three months before the actual end of the purchase programme, given the uncertainty about the near-term economic outlook and possible market pressures in conjunction with the lively debates centred around Italy that may take place at the EU Summit on 28-29 June. So far, market conditions have been broadly unchanged despite the Italian crisis, as a renewed decline in Bund yields and EUR depreciation have broadly offset the widening of sovereign and credit spreads. We know that the ECB is monitoring financial conditions cautiously as the GC considers that a large degree of support is still required to ensure a convergence of inflation towards its target. Therefore, we expect the GC to make sure that its decision does not lead to an unwarranted tightening of market conditions.

Goldman agrees:

We do not expect any concrete policy announcements at the June meeting. We expect President Draghi to indicate that the changes to the APP and forward guidance are likely to come in July (or possibly even September), as the current guidance (which extends to end-September for the APP) will need to be updated. This may include reporting on the Governing Councils initial, yet inconclusive, discussions at next week’s meeting around the future of the APP. But for now, we think the ECB will — as Mr. Draghi said in April — keep a steady hand, awaiting further macro data.

All of that said, it’s worth noting that the rates market has completely faded the possibility that the Italian turmoil will force a meaningful dovish relent:

Remember, rates won’t be hiked until after APP is over and if you believe Villeroy, we’re most assuredly talking about “quarters” not “years” on that (and for fuck’s sake, if it does turn out to be “years”, well then something has gone horribly wrong).

Forward guidance on APP is thus effectively forward guidance on rates and what you see in that chart is the market initially pondering whether the Italian situation would force a rethink from the ECB only to pretty much immediately fade that possibility, presumably after Five Star and League managed to avert new elections.

So that’s where everything stands for the ECB headed into the June meeting, updated projections and presser, which will of course come just hours after the Fed decision.

Steel yourself.