Given the last week’s flurry of positioning by key ECB policymakers, adding sovereign bond purchases to the ECB’s asset purchases is increasingly likely. If indeed we are right in our scenarios of lasting lowflation (with the recent oil price weakness likely to result in negative inflation next year) and a balance sheet expansion of only €450bn under the current purchase programmes (including corporate and agency bonds), venturing into buying sovereign bonds is indeed the logical conclusion. A large minority opposing such move is unlikely to change that dynamic, and would not be in line with the Treaty.
1) we see low growth and inflation in the euro area, with high downside risk, lasting for an extended period. The background of weak demand in the euro area suggests a real risk of inflation expectations becoming un-anchored more permanently, while weaker headline inflation also implies higher real interest rates which could spill over into core inflation. This is thus a material threat to the ECB’s key mandate of delivering price stability, requiring a policy response. In an alternative inflation scenario where oil prices fall to $70 and stay there, headline inflation would be negative for most of the first half of next year;
2) we also doubt the ECB will reach much further than €450bn in balance sheet expansion, incl. purchases of corporate and agency bonds (we expect a take-up of only around €145bn take-up in the December TLTRO and only around €200bn in ABS/Covered bond purchases as the ECB tries to avoid holding more than 20% of eligible assets in order to maintain some liquidity). As there is a declared expectation for a balance sheet expansion of €1 trillion by the Governing Council, we see added urgency to come close to this target.