Covid-19: ECB’s ‘shock and awe’

Main points:

*Cash is the current overriding concern for individuals, companies and suppliers

*The outlook is turning more negative on government bonds

*A single, pan-European bond issue could be moving closer to reality

The European Central Bank’s (ECB) latest (and much larger) response to the market fallout from the Covid-19 crisis is far more impressive than what it initially pledged last week, and more in line with what the market had been hoping for. The ECB’s initial response to the crisis had been to announce only a modest increase in its quantitative-easing (QE) programme, and this, together with very poor market liquidity, pushed sovereign spreads in the euro area wider versus German bunds, defying comments from ECB President Christine Lagarde that this would not be allowed to happen.

This latest €750bn debt-buying package is notable not only for its size, but because for the first time it includes Greek government bonds in the purchase plan. We would anticipate that these purchases should provide some backstop to the rise in non-German sovereign-bond yields, along with extra support for the corporate bond market.

Given the US Federal Reserve’s experience with QE this week (it had already spent $175bn and yields still rose, it wouldn’t surprise us if the ECB comes back to the table for a third time to promise further financial support to bolster the escalating fiscal deficits around the eurozone.

Turning negative on government bonds

The occurrences of the last few days have led us to turn negative on government bonds, because as economies run the risk of grinding to a standstill in the current crisis, cash becomes the overriding concern for individuals, companies and suppliers who need to get paid.

The central banks are trying their best by slashing interest rates, but it is the availability of money that is the problem, rather than its price. For us, government spending through initiatives such as tax cuts, benefit increases or loan guarantees is the only answer, as such actions will supply the necessary cash to allow businesses and individuals to keep going.

QE helps because it finances some of the government spending, but it will still require a substantial issuance of bonds, which is putting upwards pressure on bond yields as we have seen play out this week. In these unprecedented times, as has been mooted again over the last couple of days, a pan-eurozone bond where all members issue as one group, could be on the cards. Could Germany finally be willing to share its AAA credit quality?

Authors

Jon Day

Portfolio manager, Fixed Income team