The size and extent of risk mutualisation are not unrelated when it comes to the design of ECB QE. We know that the direction of travel when it comes to government bond purchases has been toward risk de-mutualisation, where sovereign risk stays at the national central bank/country level.
But a mutualisation of risk will still happen if the ECB decides to include additional assets in QE on top of ABSPP and CBPP3. The advantage of widening public asset purchases to include corporate and supranational bonds is that it would allow a QE programme to go beyond €500bn and towards €1trn.
German board members to dissent
While German members of the ECB (Weidmann/Lautenschlaeger) will likely vote against QE, the key is that in order to get broad agreement, certain compromises are likely to have been made. Risk de-mutualisation, is likely key in getting some of the hawks, such as Knot, to support the programme.
A conditional inclusion of GGB?
An ECB QE programme that excludes Greece could risk increasing the chances of Grexit. The Greek Ekathimerini website this week ran a story with the headline headlined “QE exclusion a ‘de facto Grexit’” citing the Finance Ministry as saying:
1) it would be unprecedented for Greece not to benefit from a euro wide ECB decision
2) put an end to Draghi’s pledge to support Greece as long as it is in a program and
3) it will create two-speed yields in state bonds within the eurozone.
It seems that instead of excluding Greece completely the ECB could follow the example of the OMT and make purchases conditional upon Greece being in a support programme and only after a satisfactory resolution to the Greek election.
Q&A to dilute any dilution of QE
The Q&A will be used by Draghi to highlight the potential for larger QE and a more open-ended version than that officially presented and signed off by the governing council. This alternative scenario is likely to have a bigger market impact, as currently there is a strong consensus that the ECB will need to do more QE and that would also be consistent with what was seen from Fed and BoE programmes.
Greek election and disagreement could see modalities delayed
There is the prospect that the ECB could pre-announce QE but not deliver the modalities until at a later date. This would help to take the ECB beyond the Greek election but also provide time to settle residual differences. The modalities could be released along with the minutes but likely ahead of the March ECB meeting given the maturing of 3y LTROs that will reduce the ECB’s balance sheet.
Market reaction
While it seems clear that QE will be announced this week, it remains uncertain what kind of market reaction will follow. At the very least plenty of volatility is to be expected. The risk then would be that, having bought the rumour, the market will sell the fact once QE is announced. With oil prices now having stabilised, we may get a sharp correction on Bund/peripheral yields in a similar fashion to what happened after the Fed and BoE announced their QE programmes. (Full Story).
We retain our bias toward holding puts on both EUR/USD and Bunds. When the BoE and Fed announced QE their respective 10yr yields were higher by some 80-100bp over the following 3-4 months. For a chart of 10yr Treasury and Gilt yield performance into and following QE see http://link.reuters.com/xes72w.
While EUR/USD looks oversold, we still see the risk that the downside will accelerate the pace of EUR weakness. We continue to favour holding downside structures on EUR/USD and recently converted our 1.15 EUR/USD puts to 1.10-1.15 put spreads
