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The Market Weighs Draghi's QE

My respect for Mario Draghi grows. He navigated the eclectic, passive aggressive minefield that is the EU, offering sacrificial gambits to Germany in exchange for positioning that would ultimately lead to, well, exactly what he wanted. He finally got it: balance sheet expansion.

The program in outline entails €1.1 trillion for asset purchases of eligible securities, of which €45 billion euros are monthly purchases of sovereign debt, €5 billion euros are institutional and agency bonds, and €10 billion euros of existing asset purchase programs. There is a proviso that purchases are limited to no more than 25% of each bond issue and no more than 33% of each issuer’s total bond issuance. To keep Weidmann and his camp happy, the ECB is only at risk for 20% of the purchases, individual national central banks assume the remainder of the risk. See what I mean about offering gambits?

Anyway, credit received confirmation of purchases before the program was outlined, and wasn’t disappointed by the details. These are big liquid indexes, and both of them caught a bid when the program was announced. Note that European credit clearly started front-running in early January. Credit overall is pricing in a clear stimulus effect.

Draghi QE.jpg

The real question is what the program will accomplish. If the idea is to shore up distressed credit, sovereign debt purchases is a puzzler. While they caught a bid, their yields clearly weren’t distressed to begin with. If that is the objective, then purchase corporate debt—say, Portugal Telecom or a name like it. This would inflate asset values rather than drive sovereign yields even more ridiculously lower.

If the objective is to re-inflate the EU economy or somehow ignite inflation expectations, well, the market is not convinced of success. At all. To see this, have a look at Italy.

Italy has a very deep bond market. The republic of Italy issues both nominal bonds and linkers—in the States we call these bonds “TIPS”—they are bonds that offer a yield that is indexed to inflation, typically CPI. Even though the amount of nominal debt issued is much, much bigger than linker issuance, there are associated liquidity differences, and differences in tax treatment, the bond-linker spread, called the inflation break-even, remains a time honored and meaningful way to assess inflation expectations. This spread is signaling no dice on inflation.

Italian linkers.jpg

Yes, these are generic bond indexes with different maturity compositions and OTR and OFTR constituents; plus, as I already mentioned, the instruments are to some degree different. These considerations matter at the margin. However, in the large they are a technicality that may influence levels to some small degree, but certainly not the directionality.

The market bought into inflation expectations with its first experience with ECB bond purchases in the dire times of late 2010. Beginning in September 2012, inaction (for lack of a better word) resulted in a cratering of inflation expectations, persisting pretty much through today.

The planned QE is not moving the needle. Nominal bonds are the chief beneficiary post-announcement. To really influence inflation expectations, the ECB needs to meaningfully undertake Credit Easing (CE)—purchases of risky corporate debt, loans, buying debt on the secondary market. This kind of stuff will shake up expectations.

As it is, bank equity will again be the chief beneficiary, so that is the place to be. Intesa, Santander, Unicredit among other are already seeing their credit spreads tighten materially. EU periphery bank equity, an option on underlying bank assets, are arguably undervalued given that big chunks of their assets are going to be re-inflated. Preferable to 100 bps or even less on 5Y EU govt bonds.

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