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Markets were considerably calmer in May even as data continued to reveal the scale of economic devastation caused by coronavirus lockdowns. A German court ruling created some uncertainty around the limits to ECB quantitative easing, while moves by the European Commission to create a €750bn recovery fund was more warmly received by markets.
The Governing Council of the European Central Bank (ECB) last met on 30 April, keeping policy rates unchanged as widely expected: the deposit rate at -0.50%, the main refinancing rate at 0%, and the marginal lending rate at 0.25%. The ECB made a further reduction to the interest rates on the TLTRO-IIIs by 25bps so that banks can now take the funds at -1.0%. Additionally, a new series of seven pandemic emergency long term refinancing operations (PELTRO) were announced; monthly operations with maturities of around one year will be offered at the refi rate less 0.25%, commencing in May. On the purchase programs, the ECB did not announce anything specific — no increase, no new assets and no extension, although ECB President Christine Lagarde made it clear that the ECB remains fully committed to support its euro members in all jurisdictions. The ECB next meets on 4 June 2020.
The ECB faces a challenge from the German Federal Constitutional Court (GFCC), which delivered its judgment on the ECB’s Public Sector Purchase Programme (PSPP). It ruled that both the European Court of Justice (ECJ) and ECB had acted ultra vires (beyond their legal authority), as both had inadequately assessed the proportionality of PSPP. The main argument suggests that ECB measures were “not proportional” to monetary policy objectives and that they had veered in to economic and fiscal policy areas. This has raised market concerns about the ability of the ECB to sufficiently conduct future quantitative easing. The ECB will have to be more careful in the way it justifies its asset purchases and we have already noted that “proportionate” is being used by the ECB. Peripheral spreads widened and the euro weakened after the ruling.
The European Commission has proposed a recovery fund totalling €750 billion, which aims to underwrite the worst-hit parts of the eurozone such as Italy and Spain; this would be split as €500 billion in grants and €250 billion in cheap loans. This followed a joint push from France and Germany, who had suggested that the EU borrow €500 billion, that could be allocated as grants. The program still requires backing of the member countries and negotiations will be challenging, even with Germany/France’s “blessing”. Austria, Denmark, the Netherlands and Sweden have signalled their resistance to handing out too much money as grants. The program would be funded by joint debt issuance, a significant step towards closer financial integration. They are next scheduled to meet on 19 June, with both the EU’s next seven-year budget and the recovery fund on the agenda.
Given the depth of the contraction, low and falling inflation expectations, and the risk of a further widening of government yield spreads, the ECB may step up its Pandemic Emergency Purchase Programme (PEPP). The ECB may make changes to the composition and duration of the program. Officials have additionally debated whether to remove the constraints on its bond buying, particularly the size restriction of the euro constituent economies. Purchases up to the 22 May totalled €211.858 billion (averaging approx. €26 billion per week) with market forecasts that €750 billion of purchases may be reached by September or October — so perhaps by moving at the June meeting, the ECB will want to avoid unwarranted speculation.
Eurozone growth saw an unprecedented decline in the first quarter, with both the manufacturing and services sectors severely impacted. GDP declined -3.8% q/q in Q1, reflecting the downturn due to the lockdown. Speaking at an online seminar, ECB President Lagarde revealed more pessimistic expectations, forecasting a contraction of between -8% and -12% for 2020. The ECB stated that revised projections would be announced at the June meeting.
Eurozone headline inflation fell further, down from 0.3% in April to 0.1% in May. Food inflation eased back from April’s high, but energy prices remain the main driver for the collapse, falling 12% compared to a year ago. The core rate (which excludes energy, food and tobacco) held at 0.9% in May. Market expectations are for headline inflation to move lower, with a Bloomberg survey indicating expectations of 0.4% in 2020 and 1.2% in 2021.
Unemployment in the euro area showed a small increase up to 7.4% in March from 7.3% in February. This is not reflective as to what is likely to come from April onwards; expectations are for this to be much higher, with forecasts as high as 9%, in the wake of the pandemic and lockdown.
Data releases in May provided further evidence of how badly the eurozone economy has been affected by the pandemic. Eurozone retail sales dropped to 2014 levels, declining 11.2% in March with expectations that April will be lower. Already, we have seen Spanish retail sales falling by 32% in April, following a 14% drop in March (nearly three times as severe as the 2012 eurozone crisis). Purchasing managers’ indices (PMIs) fell to new record lows in April, with the composite index reading for Germany at 17.4, Italy at 10.9 and Spain at 9.2. The eurozone Economic Sentiment index showed a small improvement, from 64.9 in April, to 67.5 in May. Although business sentiment improved in industry, it fell further in services — where the effects of the lockdowns and social distancing continue to weigh on firms such as restaurants and hotels.
The Euro Overnight Index Average (Eonia) averaged a yield of -0.46%, remaining stable over the month. Short-end cash was stable, trading 10-15 bps lower than Eonia. Excess liquidity deposited with the ECB increased over the month, reaching an historic high at month end at €2.134 trillion, averaging €2.105 trillion in May.
Euribor stabilised with the ECB providing heavy liquidity, cross currency arbitrage evaporating as USD libor fell and relief in peripheral spreads. One-month Euribor averaged -0.464%, ranging -0.445% to -0.482% before closing at -0.482%, approx. 2 bps lower than April; three-month Euribor averaged -0.272%, ranging -0.245% to -0.307%, closing May at -0.307%, 3 bps points lower than April. Six-month Euribor averaged -0.144%, ranging -0.114% to -0.165%, closing at -0.158%; one-year Euribor averaged -0.081%, ranging -0.58% to -0.108%, closing at -0.085%, 1 and 3 bps higher, respectively.
Euro-denominated short-dated core government bills traded higher as supply increased, ranging from -0.52% to -0.62%. Three-month French Treasury bills ranged -0.48% to -0.55% in May, closing at -0.52%. Overnight government repo markets stabilised, ranging from -0.55% to -0.60%. Bank cash deposits were stable between -0.60% and -0.55% over the month.
Global government bond markets were calmer in May. Central banks and governments have launched unprecedented moves to provide liquidity and support to their economies. There continues to be market discussions as to whether negative rate policy will be on the agenda for both the Federal Reserve and the Bank of England. Ten-year US Treasury yields stabilised, beginning May at 0.61% and closing higher at 0.65%, with a high 0.73% in the month; 10-year German Bund yields moved higher, beginning May at -0.59%, closing at -0.45%, with a high of -0.42%; 10-year UK gilt yields moved lower, beginning May at 0.25%, closing at 0.18%, with a high of 0.27%. Italian debt saw some relief as details of the EC recovery fund was revealed, with strong buying seen in five to ten-year BTPs, with 10-year bond yields falling to 1.47% at the end of May, compared to 1.76% in April.
At the fund level, the weighted average maturity (WAM) averaged 29 days in May. European money markets continued to show encouraging signs of recovery, with strong activity, as investor and market confidence returned. Investments were targeted out to one month, with selective investments out to three months. Short-term liquidity ratios remained high in both overnight and one-week maturities. Fund liquidity was covered with a combination of government and agency holdings, government/supranational repo and bank deposits. The fund always maintained a high credit quality.
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