Rates Spark: A Horse Desgined By A Committee

Yesterday's ECB meeting proved a non-event. Attention now turns to the EU council summit. We're expecting progress but, save for a few smaller countries, the benefit should fall short of a game-changer. Still, the way is clear for further spread tightening. Core EUR and USD rates on the other hand still face downside due to the resurgent Covid-19 epidemic.

Source: Bloomberg, Eurostat, ING

ECB: pleasantly uneventful

President Lagarde provided markets with the assurance they needed ahead of the summer stretch - that nothing would change with regards to ECB policy given still elevated scenario uncertainty. This also left the door open for further easing after summer for which our economists still see a case in September or October. It should also limit the downside risks for markets stemming from the EU summit kicking off today.

Stable BTP-Bund spreads and lower Bund yields going out of the ECB meeting are also a result of Lagarde clearly dissuading the notion that the envelope of the Pandemic Emergency Purchase Programme would not be spent in full. According to her, this would only occur in the case of very significant upside to the economic forecasts; the baseline remains that the entire €1.35tr will be deployed and the entire horizon until mid-2021 utilized.

Only after the press conference, a report surfaced saying that policy makers did not agree on this matter, perhaps due to diverging opinions about the strength of the economic rebound. That said, purchases have slowed and should continue to do so in the summer months. But this should be read as a reflection of the programme’s inherent flexibility and thus a response to the improvement of market conditions. Lagarde still remarked that financial conditions remained tighter compared to pre-COVID-19 times judged by higher sovereign yields in some jurisdictions.

The ECB abstained from any technical tweaks this time around. Adjusting the tiering multiplier to exempt more of banks' liquidity from the penalty deposit facility rate was not discussed. Lagarde stressed that the experience with tiering was positive, which included its contribution to lowering the fragmentation in funding markets. She added that the multiplier and rates could be changed, but saw no need to do so at the moment.

Greece and Portugal to be clear recovery fund winners

With the July ECB meeting firmly behind us, the EU Council summit starting today is now the main event risk before summer trading conditions assert themselves. Our base case is for progress to be made towards an EU recovery fund, but for the final agreement to take place only at a later date. In detail, our economics team sees a compromise around a €600bn package split in equal part between grants and loans as possible.

We expect this outcome would be welcomed with cautious optimism in financial markets. Looking at the European Commission proposal, arguably an optimistic scenario compared to the final outcome, some countries will be clear winners from the fund. Greece and Portugal are in that group. Comparing the expected disbursement to their 2019-21 borrowing needs, it seems likely that the fund will make a significant difference for these countries.

EU recovery fund benefit vs GDP and vs borrowing needs

Source: European Commission, ING

A horse designed by a committee

Italy and Spain should also be net beneficiaries but we would stop short of forecasting lower debt issuance as a result. Still, their respective bond markets should benefit at the margin from a display of European solidarity, and from a signal that long-term Eurozone financial integration is back on the agenda. In numbers, a swift agreement would push 10Y Italy-Bund towards our 150bp target by the end of the summer.

As often with EU policy, the devil will be in the detail. There is no certainty at this stage about the amount, allocation key, nature (grants or loans), conditionality, or timing of the disbursements. It may well be that the eventual outcome is all but a trickle of money reaching large peripheral countries over a 7-year period. We would thus stop short of joining the chorus calling it a game-changer, from the point of view of rates markets.

European supranationals: a paradigm shift

Interestingly, the most momentous outcome of today’s EU summit could be for the Eurozone supranational bond market. The EU said this week it expects nearly €100bn of debt issuance related to the SURE programme between September 2020 and 2Q21, after necessary guarantees are agreed by member states. This would roughly equate to €5bn of debt sales every other week during that period.

A front-loading of a third of a €600bn EU recovery fund in 2021 would add €200bn to this tally, a lot more than what this market is used to absorbing in any given year. For comparison, gross €-bond issuance from the EIB, EU, EFSF, and ESM averaged €67bn per year in 2015-19. It is also likely that a decent chunk of this issuance will carry green and or social labels. Both, we think, call for heavier ECB intervention.

Greater Eurozone supra issuance is likely to be met with a greater amount of PEPP and PSPP purchases going towards this asset class. Whether this is detrimental to government bonds depends on whether the PEPP envelope is topped up in the autumn. Greater green and social bond issuance would also provide the ECB with a golden opportunity to show it is committed to achieving its climate change goals.

Events today: EU summit, ECB speakers

The main event today is the first day of the EU summit with the recovery fund high on the agenda (see above). The meeting will stretch well into the weekend so we're not expecting much by way of soundbites during today's trading session, and we would argue against acting on them.

The ECB meeting is over but two prominent governing council members are due to speak today: Schnabel and Guindos. In light of reported disagreement about the future of PEPP, their comments will be closely monitored. Schnabel, in particular, could offer more detail on her view that not all of the envelope will be spent. Note also that chief economist Lane has published blog posts the day after recent ECB meetings so we might see one today. Lastly, the survey of professional forecasters is also published this morning.

Aside from the EU, BOE governor Bailey speaks today. On the data front, US housing starts, and the University of Michigan sentiment are the two main releases.