BNP ECB QE Revisited

8/12/2019 BNP ECB QE Revisited

http://slidepdf.com/reader/full/bnp-ecb-qe-revisited 1/34

www.GlobalMarkets.bnpparibas.com Please refer to important information at the end of the report.

Market Economics | Credit | IR & FX Strategy

ECB QE revisited17 July 2014

Page

2-3

We analyse the market implications of the reduced probability of ECB QE.

Economics

QE: Failure to launch 5-14

The probability of a broad-based asset purchase programme has fallen following June’s package of measures, which

the ECB is confident will be sufficient to ward off the threat of deflation. We are less convinced and still see good

reasons for doing more. But this is now a risk rather than a central scenario and we have changed our policy forecast

accordingly. We look at the reasons the ECB is reluctant to launch such a programme.

Implementation of TLTROs

The four phases 15-17

We have split the eight available TLTROs into four distinct phases. Banks whose recent de-leveraging has outpaced

their 12-month average might want to use their maximum allowance in Phase I, while banks which have recently

experienced steep de-leveraging could find it easier to borrow during Phase II than Phase III.

Market implications

FX: No QE implies slower EUR depreciation, but stay short 19-20

Money market and ccy basis: Still ample excess liquidity 21-22

Core/semi-core rates and inflation: ZIRP to keep rates and breakeven inflation low 23-25

Peripheral bonds: Worse risk/reward 26-30

Credit: No QE, no cry 31-33

Contacts

Paul Mortimer-Lee Global Head of Market Economics +44 20 7595 8551 [email protected]

Ken Wattret Co-Head of European & CEEMEA Market Economics +44 20 7595 8657 [email protected]

Laurence Mutkin Global Head of G10 Rates Strategy +44 20 7595 1307 [email protected]

Patrick Jacq Europe Strategist +33 1 4316 9718 [email protected]

Shahid Ladha Head of UK Strategy & European Inflation +44 20 7 595 8573 [email protected]

Ioannis Sokos Europe Strategist +44 20 7595 8671 [email protected]

Camille de Courcel Europe Strategist +44 20 7595 8295 [email protected]

Olivia Frieser Global Head of Credit Research and Sector Specialists +44 20 7595 8591 [email protected]

Greg Venizelos Senior Credit Strategist – Europe +44 20 7595 8296 [email protected]

Daniel Katzive Head of FX Strategy North America +1 212 841 2408 [email protected]

Non Independent research - Marketing Communication

Overview

mailto:[email protected]























17 July 2014

ECB QE revisited 2 www.GlobalMarkets.bnpparibas.com

The probability of the ECB implementing QE in the form of a broad-based asset purchase

programme (BAPP) has fallen, following the package of measures announced in June, and this

is no longer our central case.

The TLTRO programme, without a BAPP, implies a somewhat different outlook for financial

markets from our previous central case of ECB buying of sovereign bonds.

The still-ample provision of liquidity via TLTROs means that we still expect the money-

market curve to stay very flat, and the cross-currency basis to fall and the euro to weaken, albeit

by less than previously expected.

But without ECB buying of sovereign bonds, we are now considerably less optimistic

regarding the outlook for inflation expectations and sovereign spreads. We now expect that

inflation expectations will continue to languish, keeping nominal core rates low, and we no

longer expect a further tightening of peripheral spreads this year.

These points are discussed in more detail below.

Note: For the sake of clarity, in this publication we use the term ‘broad-based asset purchase

programme’ (BAPP) to describe large-scale ECB buying of assets, including sovereign bonds,

for monetary policy purposes, as well as the less precise term ‘quantitative easing’ (QE).

Economics

QE: Failure to launch

The chances of the ECB launching a broad-based asset-purchase programme have fallen,

given June’s package of measures. With inflation to remain uncomfortably low, the ECB will

keep QE as a contingency option but unless forecasts change, it will probably not deliver.

While we had long expected persistently low inflation to prompt the ECB to deliver a range of

policy initiatives, key aspects of June’s package went beyond our expectations. The

exceptionally long maturity of the TLTROs and their limited conditionality were the mainsurprises and could generate similar effects to QE in some areas.

Recent comments from a range of ECB officials highlight the central bank’s high level of

confidence that the measures already announced will have substantial effects. We are less

convinced. We continue to see downside risks to the ECB’s inflation projections and believe

there is a case for doing more.

There are various potential shocks that could yet force the ECB into a broad-based asset-

purchase programme. Inflation, growth and the exchange rate are key swing factors.

We look in detail at the ECB’s underlying objections to a QE-style programme.

Implementation of TLTROs

The four phases

- Phase I: Sep-14 and Dec-14 based on stock of qualifying loans

- Phase II: Mar-15 and Jun-15 based on existing trajectory of lending

- Phase III: Sep-15 to Jun-16 based on trajectory of lending vs April 2015

- Phase IV: Sep-16 mandatory repayment test based on cumulative lending

Banks whose recent de-leveraging has outpaced their 12m average might want to use their

maximum allowance in Phase I, as they may not be able to beat the benchmark in Phases II

and III.

Banks which have recently experienced steep de-leveraging (eg Spanish) could find it easier toborrow during Phase II than in Phase III.

Overview



17 July 2014


Market implications

FX: No QE implies slower EUR depreciation, but stay short

We raised our EURUSD forecast targets modestly, to reflect reduced prospects for ECB QE.

We continue to expect the EUR to trade broadly weaker in H2. We favour EURUSD and

EURGBP shorts and recommend funding risk and carry positions in EUR.

Money market and ccy basis: Still ample excess liquidity

TLTROs will lead to a smaller extension of excess liquidity with a slightly shorter duration than

would be the case with a BAPP, but ample excess will remain.

The money-market curve therefore looks too flat to us.

EURUSD cross-currency basis will not widen as much as with QE, but should still reach -12bp

in 5y by end-2014.

Core/semi-core rates and inflation: ZIRP to keep rates and breakeven inflation low

ZIRP implies low volatility and low core rates: we expect 5- and 10-year to further outperform on

the curve. Without QE, the market will remain sceptical that inflation will revive, keeping break-

even inflation and core nominal rates under downward pressure.

Semi-core and SSA spreads should benefit from a zero interest rate policy: we maintain our

forecasts for tighter SSA & semi-core spreads.

Peripheral bonds: Worse risk/reward

TLTROs differ from both 3y LTROs and QE in two important ways:

1. The size and use of the borrowed funds from TLTROs will remain uncertain, providing a

less transparent exit point for investors who have been purchasing peripherals in

anticipation of QE.

2. TLTROs reinforce the link between sovereigns and banks whereas QE could have

weakened them, setting the ground for a non-zero risk weighting on sovereign bonds.

Absence of a direct ECB bid for peripherals should lead to higher spread volatility and so to a

higher risk premium in peripheral spreads

We now anticipate that 10y Spain and Italy spreads will end 2014 at +150bp over Bunds (vs our

prior expectation of +100bp). Further, as we expect higher volatility given lower probability of

QE, we do not see peripheral spreads as cheap enough to buy below 180bp.

We expect 3y peripheral spreads to be better-supported than the 10s, due to the nature of

TLTROs. We now target +60bp at end-2014 (vs +40bp prior expectation)

Credit: No QE, no cry

The implications of a ‘no ECB QE’ scenario for the European credit markets are a reduced

degree of spread tightening in H2 2014 and less spread compression of high beta vs low beta,

Periphery vs Core, Financial vs Non-Financial and European vs US credit spreads.

Furthermore, we may see some steepening in credit curves, particularly in high beta and

periphery risk.

We expect a relatively high take-up for the TLTRO, although the EUR 1trn maximum amount

mentioned by ECB President Draghi is higher than our estimates. There is no stigma in using

the facility in our view, given that it is conditional to lending to the economy. Although, the

Central Banks may put pressure on the banks to use the TLTRO.

That said, we are not convinced that this will lead to a significant increase in lending, especially

to SMEs. The TLTRO is not that ‘targeted’ after all. Banks can continue to embark on the

sovereign debt carry trade and the net lending benchmark can be met/exceeded via an

improvement in net lending to large corporates and/or consumers rather than SMEs.



17 July 2014


Economics




17 July 2014



The probability of the ECB launching a broad-based asset-purchase programme has

fallen following the package of measures announced in June.

With inflation to remain uncomfortably low, the ECB will keep QE as a contingency

option. But there is a reluctance to deliver and we have revised our forecast accordingly.

We no longer forecast such a purchase programme in our central scenario.

While we had long expected persistently low inflation to prompt the ECB to deliver a

range of policy initiatives, key aspects of June’s package went beyond our expectations.

The exceptionally long maturity of the TLTROs and their limited conditionality were

the main surprises and could generate similar effects to QE in some areas.

Recent comments from a range of ECB officials highlight the central bank’s high

level of confidence that the measures already announced will have substantial effects.

We are less convinced. We continue to see downside risks to the ECB’s inflation

projections and believe there is a case for doing more.

There are various potential shocks that could yet force the ECB into QE. Inflation,

growth and the exchange rate are key swing factors.

We look in detail at the reasons why the ECB is reluctant to embark on QE.

ECB forced to act by persistently low inflation

Since late last year, a key theme of our eurozone analysis has been the likelihood of persistent

downward surprises in inflation prompting the ECB to deliver additional policy easing, in both

conventional and unconventional form, including asset purchases.

It took a long time for the ECB to react to persistent sub-1% inflation. On 5 June, an unusually

broad range of policy measures was announced, comprising five of the six policy options

included in the contingency framework put forward by ECB President Mario Draghi on 24 April.

The introduction of a negative deposit rate and an asset-purchase programme for asset-backed

securities (ABS) did not come as a surprise to us, nor did the extension of the fixed-rate, full-

allotment procedure for all refinancing operations (though the latter went beyond our

expectations, going out to December 2016 at least). Ending the sterilisation of asset purchases

made under the Securities Markets Programme (SMP) had also been flagged to markets by the

ECB some months beforehand.

June’s package reduces the probability of further action …

The main surprises were in the area of very long-term liquidity provision for banks. The ECB’sdecision to introduce targeted long-term refinancing operations (TLTROs) with a fixed rate was not

surprising; it was part of April’s contingency framework. The surprises were in the exceptionally

long maturity of the loans (up to four years) and the limited conditions attached to them.

In tandem with the other measures announced, the TLTRO initiative and its potential impact on

asset markets and bank lending have reduced the probability of the ECB implementing the only

policy option cited in April’s framework that was not included in early June’s package, namely, a

broad-based asset purchase programme (BAPP).

The chances of the ECB launching a BAPP have diminished and we have revised our forecast

accordingly. We no longer forecast such a programme in our central scenario. The ECB will,

however, continue to dangle the prospect in front of markets and, in the event of a significant

shock (see below), we would expect a QE-style programme to be the cornerstone of the ECB’sresponse. Below, we look in detail at a range of issues related to our change of forecast.

Unusually broad range ofmeasures in June

Length of TLTROs was thebig surprise

Chances of a BAPP haveradically diminished

http://rss-globalmarkets.bnpparibas.com/r?t=AeicBicrPESl8T0A3sWwc

http://rss-globalmarkets.bnpparibas.com/r?t=AeicBicrPESl8T0A3sWwc



17 July 2014


We had forecast that the ECB would announce a QE-style programme in September, in tandem

with another round of downward revisions to the inflation projections. The recent package of

policy measures has radically reduced the likelihood of this happening.

Some of the measures announced in June (the TLTROs and the ABS purchases) will only take

effect with a lag and it is clear that the ECB wants to take some time to assess their effects. In

the absence of a significant shock, therefore, the ECB is likely to focus on its existing initiatives

until at least December’s second TLTRO and perhaps the third window in March 2015 (the first

of the operations in which the take-up will be determined by banks’ net lending). That far down

the line, the window for a BAPP is more likely to have closed, as we expect inflation and growth

to be somewhat higher by then, while the EUR is also forecast to depreciate.

… as reflected in recent communication

The ECB’s confidence in the impact of June’s measures and its desire to take time to assess

their effects were prominent at July’s press conference. ECB President Mario Draghi stated on

more than one occasion that the impact of June’s package would be “substantial” and that has

been echoed in other speeches since by a range of ECB officials.

Executive Board member Benoit Coeuré gave little encouragement to the prospect of a BAPP inan interview with the Financial Times on 7 July. "I see the odds as being low ... I am very

convinced that what we decided already will work and will prop up inflation," he said.

Having put so much faith in June’s package, it is going to take a long time (or a major shock) for

the ECB to accept that it is has not done enough.

Arguments against QE

It is now 2014. The Fed started to conduct QE in 2008. The ECB is clearly not that enamoured

of QE or it would have undertaken it by now. What are the underlying objections to QE and the

more immediate reasons for not wanting to implement it?

The deepest reason for not wanting to quantitatively ease is the experience in the 1930s, in

particular in Germany, where central bank financing of the government resulted in hyper-

inflation. This makes the Bundesbank and others very cautious about embarking on such astrategy. It also means that the acceptability of the policy among the German public is low.

Once the Rubicon is crossed, there is a danger that central bank finance for government could

become easier on subsequent occasions. Second is the fear of moral hazard in that central

bank financing of governments reduces the pressure on governments to get their fiscal house in

order. This does indeed seem to be a risk given that the OMT seems to have reduced the

pressure on governments to “do the right thing”.

Against this backdrop what are the more immediate reasons for wishing to avoid QE, except in

extremis?

It won’t work because of the instability of the money multiplier.

QE works, so the argument runs, by increasing the monetary base, because the money

multiplier moves in a way to offset variations in the monetary base almost completely (seeChart 1). We think this is too narrow an interpretation of how QE works and in any case surely

means TLTROs will not work either.

Bond yields are already very low and QE will not lower them further.

We have some sympathy with this, though we would point out that qualitative and quantitative

monetary easing (QQME) in Japan, where yields were even lower, did lower bond yields (see

Chart 2). This ignores the fact that there is more than one bond yield in the eurozone. The

German bund yield may not fall much further, but QE would bring down the much higher real

bond yields in the periphery (see Chart 3).

The 5 June package has done all that needs to be done.

We do not buy this. TLTROs continue to try to work through bank liquidity measures. They

may work better when bank capital funding issues have been addressed though the asset

quality review (AQR). However, the demand side of bank lending remains weak, even if thesupply side is being supported, and banks’ attitude to risk (NPLs) remains cautious. QE would

ECB confident in effects ofJune measures

Deep fears of central banksfinancing governments

It won’t work?

Bond yields already low

June 5 was enough



17 July 2014


add liquidity and increase money supply ahead of a recovery in loan demand and would

symbolize a determination for the ECB to be active not passive, thereby boosting demand.

Inflation in Germany is stable around 1% (true) and the adjustments in the periphery are

merely a relative price change. When this is complete, inflation will pick up.

German inflation has surprised on the downside on a number of occasions. It looks likeGerman inflation is not only partly a function of the German output gap but also partly a

function of the eurozone output gap. Anyway, it is not just peripheral countries that have low

inflation. Inflation in the Netherlands is only 0.3% and in France it is 0.5% in spite of a VAT

hike. There is much more than a relative price change going on here since if it were just that,

the average eurozone inflation rate would not have fallen in the way it has.

Long-term inflation expectations are stable.

The 5y5y implied inflation from the swaps market is drifting slowly down. The 5y measure from

the survey of professional forecasters has edged down to 1.8% (Chart 4). While these

measures have not plunged, the fact that they are declining shows that faith in the ECB to

achieve price stability is fading, due either to perceived unwillingness or an inability to do the

job. In Japan inflation expectations became unanchored after deflation had already set in,

suggesting inflation expectations were at least partially backward looking.

The ECB does not need to conduct QE until deflation is an imminent threat.

This means it could already be too late for QE, as it will be likely to occur only in the most

adverse circumstances.

Monetary policy has reached the limit of its capabilities.

This is a counsel of despair with which we disagree strongly. For a start, the ECB clearly thinks

it could work in extreme circumstances, which is when they have said they would deploy it. If it

will work in such circumstances, why not in less challenging times? Even if we accept that

monetary policy has limited ability to narrow the output gap significantly, the really important

transmission channels in our view that the ECB seems to want to turn a blind eye to are the

currency and inflation expectations.

German inflation is justfine

Inflation expectations wellanchored

Monetary policy hasreached its limits

Chart 1: Eurozone money multiplier Chart 2: JGB yields

3

4

5

6

7

8

9

10

11

12

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

200

400

600

800

1000

1200

1400

1600

1800

2000

Multiplier

(M3 / base money)

Base money

(right axis)

EUR bn

Source: Macrobond, BNP Paribas Source: Reuters EcoWin Pro, BNP Paribas

Chart 3: Real interest rate differential Chart 4: Eurozone inflation expectations

Source: Macrobond, BNP Paribas Source: Macrobond, BNP Paribas



17 July 2014


To us, the short-term arguments look more like excuses than anything and stem from the

atavistic fear in parts of the ECB that QE will bail out fiscally weak governments and lead to very

high inflation. We would suggest this is not the experience in Japan, the US and the UK. There

are no good excuses for a bad policy.

Is June’s package enough?

We can already see beneficial effects of June’s measures on monetary conditions. Short-term

interest rates have fallen and the ECB has been successful in its attempts to dislocate policy-

rate expectations in the eurozone from those in the US and UK (Chart 5). The four-year maturity

of the TLTROs and lengthy extension of the fixed-rate, full-allotment procedure have been

pivotal in this regard.

Interest-rate divergence has not, however, done much to weaken the exchange rate. At the time

of writing, the EUR had fallen by around 2% on a trade-weighted basis (based on the ECB’s

daily measure) from its high point prior to May’s dovish press conference. This is important, as

EUR appreciation has been a key reason for the tightening of monetary and financial conditions

in the eurozone, as measured by our own proprietary indicator, the Financial and Monetary

Conditions Index (FMCI, Chart 6). The FMCI for the eurozone has now started to loosen,

though it remains much less accommodative than the US and UK equivalents.

The ECB would argue, too, that key elements of June’s package of measures have yet to take

effect. The impact of a very large TLTRO take-up on the ECB balance sheet, for example, could

lead to more pronounced depreciation of the EUR.

TLTROs matter most

We see the TLTROs as crucial to the success, or otherwise, of June’s package of measures. In

the ECB’s view, at least, the TLTROs will be very effective. In a speech on 3 July, Executive

Board member and ECB Chief Economist Peter Praet outlined his views on how the effects

would be seen through “several channels”, including the following:

Reduced term-funding costs for banks

A substitution effect on term funding in the market for bank bonds, creating a scarcity of

investible assets and reducing yields (easing funding conditions for banks, including those that

did not participate in the operations)

Knock-on effects on other segments of the corporate credit markets, lowering yields on a

range of bonds, in a similar way to the portfolio balance effect cited by other central banks

The conditionality of liquidity provision on the evolution of net lending will lead to an outward

shift in the credit supply curve, reducing the cost of borrowing while expanding new loans

Higher excess liquidity, reducing short-term interest rates.

Beneficial effects arealready visible

TLTROs key to success ofECB’s easing measures

Chart 5: Divergent policy-rate expectations Chart 6: BNPP Financial and monetary conditions indices

0 9 1 0 1 1 12 13 14 15 16 1 70.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50Implied by Futures S tr ip

Bo E

Fed Funds Rate

BoE Bank Rate

Fe d

EC B

ECB Re f i Ra te

0 0 0 1 02 03 0 4 05 0 6 0 7 08 0 9 1 0 11 1 2 1 3 14

L o o s e r

T i g h t e r

-4

-3

-2

-1

0

1

2

3

4

U S

U K

E u ro z o n e

Source: Reuters EcoWin Pro, BNP Paribas, ECB, BoE, Federal Reserve Source: Reuters EcoWin Pro, BNP Paribas



17 July 2014


We agree that the TLTROs will loosen monetary conditions in the eurozone. But we do not see

them as an effective substitute for a broad-based asset-purchase programme (see Box 1).

There is a lack of provisions in the framework to channel bank lending to the small and medium-

sized enterprise (SME) sector. Banks, therefore, may well favour expanding net lending to thoseless risky, large non-financial corporates that are less in need of the assistance.

There are other potential drawbacks to the ECB’s opting for TLTROs rather than outright large-

scale asset purchases. One is uncertainty over the take-up. While Mr Draghi talked about the

potential for a take-up of as much as EUR 1trn at July’s press conference, this will depend on a

number of factors, including, in part, banks’ will ingness to expand net lending.

With outright purchases, there would more clarity about the scale of the intervention. One could

also argue that TLTROs do not have the same ‘announcement effect’ (on inflation expectations,

in particular) of large-scale asset purchases. Breakeven inflation rates were unmoved by June’s

announcements.

Box 1: TLTROs and BAPP – similarities and differences

Similarities

Both increase bank liquidity (though whether this would increase broad money is doubtful)

Both should lower yields in the bond market

Both should increase demand for government debt

Both should soften the exchange rate

Both should stimulate growth and reduce the inflationary threat

Differences

TLTROs work through the banking system, BAPP goes around it

TLTROs should boost private credit more, BAPP government credit

TLTROs should benefit corporate credit spreads more

TLTROs have less moral hazard with respect to government behaviour

TLTROs are ‘self extinguishing’ because of their four-year term, bond purchases may mature much later

BAPP removes quantum of government debt in the market

Therefore has more powerful portfolio balance effect

Therefore reduces market risk by more

BAPP is generally at longer maturities than the four-year tenor of the TLTROs

Therefore lowers the longer end by more

TLTRO effect should be more at the short end

BAPP likely to have bigger effect on inflation expectations

BAPP likely to have bigger announcement effect on the exchange rate

BAPP would have been more immediate

Source: BNP Paribas

TLTROs not a substitutefor a BAPP

SME funding, TLTROtakeup remain uncertain



17 July 2014


Is this QE by stealth?

Nonetheless, there are grounds for taking a more positive view of their broader effects. While

TLTROs are unlikely to be a game-changer for bank lending to SMEs, the light conditionality could

be a boost for asset markets. The first two operations in September and December will allow

banks to borrow up to EUR 400bn collectively for up to four years, with no restriction on what thefunds are used for, including carry trades into sovereign debt markets, even if their net lending

picks up only marginally relative to benchmarks (which have been set rather generously).

The perceived stigma previously associated with borrowing via the three-year LTROs should

also be less of an issue this time, as the ECB, as supervisor as well as lender, will presumably

be encouraging the banks to make full use of their allowances. The introduction of TLTRO

‘groups’, whereby borrowing can be pooled between banks with “close links”, should also help

to alleviate eurozone financial system fragmentation.

One interpretation of the TLTROs could, therefore, be QE by stealth, replicating the effects of

the prior three-year LTROs, but with the added bonus of potentially increasing bank lending to

the corporate sector. Without the backstop of ECB purchases, however, there is a risk that

foreign buyers will become less keen to expand their holdings of sovereign debt, leaving yield

spreads vulnerable to widening pressures from current levels. This, in turn, could increase thelikelihood of the ECB having to launch a BAPP – a scenario we discuss below.

Comprehensive assessment also important

The timing and impact of the ECB’s comprehensive assessment of eurozone banks is also

important when considering the TLTRO framework. The ECB wants to ensure more effective

transmission of its monetary policy through the bank lending channel and will be more confident

that this will be achieved once the comprehensive assessment is completed in the autumn. (The

results of the asset quality review (AQR) and European Banking Authority (EBA) stress tests will

be published in October.)

A better-capitalised, more robust banking system should be more willing to extend credit to the

private sector, again reducing the need for the ECB to provide additional stimulus. The timing of

the comprehensive assessment was one of the reasons we thought that if the ECB were going

to be bounced into asset purchases by uncomfortably low inflation, it was more likely to happen

before the process was complete.

Being critical, however, one could contend that the ECB was focusing too much on the

impairment of its policy stance (which is the second aspect of April’s contingency framework)

when its priority ought to be the third, namely, delivering a meaningful increase in monetary

accommodation via large-scale asset purchases in order to strongly counteract the risk of

deflation. The risk that the ECB may have left it too late remains a significant concern, in our

opinion.

ABS purchase programme has longer-term effects

A key feature of our call for more policy easing from the ECB this year was that it would include

asset purchases. While this forecast generated considerable scepticism when first presented, it

ultimately proved correct. The asset-purchase programme announced, however, is centred on ABS and dovetails with the second aspect of the 24 April contingency framework, ie, impairment

of policy transmission.

While we still await the details of the ABS programme, in all likelihood, it will have little near-

term effect on monetary conditions. While Mr Draghi suggested at July’s press conference that

the pool of eligible assets was large – he cited a figure of EUR 1.4trn for the whole of the EU – a

chunk of that is in the form of residential mortgage-backed securities. With the ECB having

excluded mortgage lending from its TLTRO framework, it would be odd to for it to then intervene

in large scale in the RMBS market. Earlier housing bubbles, including in Spain and Ireland, are

a cautionary tale.

We continue to assume, therefore, that the size of the ABS buying programme will be similar to

that for covered bonds (ie, in the tens of billions) initially. The magnitude of the programme

could increase eventually as the market becomes more developed, but this will take time and

will be linked to regulatory, reporting and legal issues. While we believe the development of

alternative sources of finance for SMEs makes sense, this is really a long-term project with

Light conditionality shouldboost asset markets

Lack of an ECB buyingbackstop could be a worry

ECB’s AQR and stresstests also important

Too much ECB focus onpolicy impairment?

ABS purchases will have

little near-term effect

ABS buying only in thetens of billions initially



17 July 2014


limited immediate results. In that context, we view the ABS programme as a complement rather

than a substitute for QE.

This too is a reason for thinking that a BAPP could yet come into play. But as with the TLTROs,

the implementation of the ABS buying occurs with a lag, so it will be some time before the ECB

is able to assess its impact and conclude that more needs to be done.

Dangling the carrot

While we have concluded, on the basis of recent developments, that the ECB is now unlikely to

launch a BAPP in the absence of a shock, it will continue to dangle the prospect carrot-like in

front of the markets. Speeches have, and will continue to, make this clear. The idea presumably

is to emulate the effects of OMT by threatening to take action but not delivering. So, what could

force the ECB’s hand?

Various shocks could put QE back in play …

Various shocks could bounce the ECB into adopting a BAPP. Three are particularly important,

in our view: (1) lower inflation and inflation expectations, (2) a worsening of the economic

outlook, widening an already large, persistent output gap, and (3) tighter monetary and financial

conditions, either via a stronger exchange rate or due to renewed stress in other asset markets.

… including downward surprises in inflation and inflation expectations

The ECB has expressed increasing concern about the potential risks associated with

persistently low inflation, citing three issues, in particular: (1) the diminishing safety margin, or

cushion, against a deflationary episode, (2) the more difficult competitiveness adjustment in the

periphery and the potential implications for debt sustainability, and (3) the adverse effect on real

interest rates and the monetary policy stance. Its rhetoric has changed markedly to reflect these

concerns, with the prospect of a BAPP explicitly linked to the risk of “too prolonged a period of

low inflation”.

How low is too low? A move close to zero in the headline HICP inflation rate from the already

low 0.5% currently would be a big deal in our view, though some Governing Council members

appear to set the threshold for a further policy response rather higher. In a recent speech, for

example, German Executive Board member Sabine Lautenschlaeger suggested that a BAPPwould only be considered in a “true emergency” such as “imminent deflation”.

In our forecast, we expect that headline inflation will go broadly sideways in the coming months,

before picking up a little in Q4 (albeit due to base effects). The ECB expects inflation, over time,

to rise back towards its “below, but close to 2%” definition of price stability. If this diminishes in

probability, the likelihood of the ECB having to deliver more policy easing will increase.

However, in various speeches recently, ECB officials have stated that there is a low probability

of the kind of persistent low inflation which would prompt a BAPP. We are sceptical about the

timing and the speed of the pickup in underlying inflation in June’s staff projections. The output

gap is still very large and we expect core inflation to remain lower for longer than the ECB

expects. Risks to price stability, contrary to the ECB’s view, are still to the downside, in our

opinion.

Expectations are important

The extent to which inflation expectations remain unanchored will also be a pivotal influence on

ECB policy. June’s policy announcements will have reinforced its belief in the “firm anchoring” of

eurozone inflation expectations, though, again, we are less convinced. The five-year

expectation in the ECB’s Survey of Professional Forecasters, while still “below, but close to

2%”, is fairly inert and conditional on the implementation of appropriate policy. In contrast, the

two-year survey has fallen to record lows and suggests that the ECB is losing credibility.

Market-derived measures of inflation expectations have fallen according to Mr Praet and market

participants “seem to factor in a longer period of low inflation”. We would argue, given this

backdrop, that the ECB should be more willing to take the more radical action, in the form of large-

scale asset purchases, required to raise inflation expectations.

ECB to continue to danglethe carrot of a BAPP

Various shocks could leadthe ECB to adopt a BAPP

When is inflation too low?

Untethered expectationsto play a key policy role



17 July 2014


Large, persistent output gap

A key reason we are sceptical about the pickup in core inflation expected by the ECB staff is the

large, persistent output gap in the eurozone. Historically, such circumstances have not signalled

a turn in the inflation trajectory until much later.

Should the economic situation in the eurozone deteriorate significantly, this would increase thelikelihood of those disinflationary forces intensifying. This would undermine the credibility of the

projected pickup in inflation and, potentially, unanchor inflation expectations. An ECB response

in the form of a BAPP would, therefore, be very likely, in our view.

The weakening of some leading indicators of economic activity in the eurozone recently merits

close attention. However, the deterioration has been confined to manufacturing sector data to

date, with domestically driven indicators less affected. Moreover, in level terms, most of the

reliable gauges of growth (such as the composite PMI) suggest that while momentum has

stalled, the economy will continue to expand.

The pickup in eurozone growth we expect to see from late this year and through 2015 as

monetary conditions ease, bank lending picks up and global growth accelerates would, again,

be consistent with the view that if the ECB does not implement a BAPP fairly soon (which islooking less likely), the chances of i t happening will diminish over time.

Exchange-rate effects

While the ECB does not target the exchange rate, its impact on monetary conditions and

inflation make it a key swing factor when it comes to assessing the likelihood of a BAPP. The

ECB is probably disappointed that June’s measures have not had a bigger effect on the EUR,

though the effect of the TLTROs on the ECB’s balance sheet will take time to filter through.

Moreover, the current EURUSD rate is below the ECB’s assumption of a stable 1.38 rate in

June’s projections, which is very different to March’s projections. Then, the EURUSD rate rose

well above the assumption of a constant rate of 1.36 (peaking just shy of 1.40 ahead of May’s

dovish press conference).

A 10% rise in the effective EUR rate would, other things equal, boost inflation by around 0.4pp.

Using the assumption of 1.38 in June’s ECB projections, a move up to 1.45 would probably be

required for the staff inflation projections to change markedly.

How EURUSD evolves will be sensitive to US developments and the ECB seems keen to wait

for a pickup in US economic conditions. This would improve eurozone growth prospects, boost

confidence and lift asset markets, while normalisation of Fed policy should help soften the EUR.

If the ECB does not embark on a BAPP in the next couple of quarters, therefore, as it wants to

take time to gauge the impact of June’s measures, the window is more likely to close on such

programme as, by early 2015, US economic and policy conditions could reinforce the ECB’s

belief that there is no need for further action.

Market turbulence

The exchange rate is, of course, one potential route to tighter monetary and financial conditionsin the eurozone. Renewed turbulence in other asset markets could also increase the downside

risks to growth and inflation. For example, renewed tensions in sovereign debt markets related

to a deteriorating outlook for growth and fiscal dynamics.

This would raise the likelihood that the ECB ends up launching an asset purchase programme,

though there is a question as to whether OMT or a BAPP would be appropriate.

Not out of the woods yet

Our view is that the safety margin against deflation in the eurozone has worn perilously thin and

from a risk-management perspective, therefore, we believe there is a compelling case for the

ECB to do more. The eurozone is one economic downturn away from deflation, with potentially

serious consequences for debt sustainability. A large-scale purchase programme, with the clear

objective of raising inflation expectations, would be a sensible insurance policy at this point.

Some on the Governing Council probably favour taking out the insurance but they have beensilent so far.

The eurozone’s big outputgap makes us sceptical

The longer the ECB stalls,the less likely a BAPP

Effects on EUR will taketime to filter through

EURUSD will depend onUS developments

New market tensionscould prompt a BAPP

Safety margin to deflationis now perilously thin



17 July 2014


We think they should but expect that they will not and so there is certainly still a risk, in our view,

that the ECB will commit a policy error and end up doing too little, too late.

What if?

We have had little guidance from the ECB about the potential modalities of a BAPP, aside from

a few references here and there in some speeches. If the ECB was forced to launch this kind ofprogramme, the timing of it and the reasons for it would be pivotal to its size and composition.

We assumed in our scenario of a September announcement that the ECB would ‘get away’ with

a relatively small shot of EUR 400bn, equivalent to around 5% of GDP (small, that is, compared

with the cumulative purchases of other central banks, rather than its first instalment). But this

was based on a scenario in which inflation was low and growth was improving and expected to

benefit from a pickup in global economic conditions thereafter. In other words, the ECB would

act somewhat pre-emptively in order to ward off the threat of deflation.

The bigger the shock and the longer the ECB stalls on delivering what we would consider to be

the most effective response of the options still available (QE), the greater the likelihood that the

asset purchase programme would have to be much larger in scale.

We calculate that on the basis of the purchases programmes of other central banks, it takes QEof around 1% of GDP to achieve a 0.6% depreciation in the effective exchange rate. As a 10%

fall in the EUR effective exchange rate would raise inflation by around 0.4-0.5pp, this would

imply that the ECB needed a purchase programme of around 12% of GDP, or EUR 1.1trn.

The size of any programme influences significantly the type of assets bought. If small in scale –

EUR 400bn, say – the ECB could avoid buying sovereign debt if it really wanted to. The

corporate and supranational markets are sufficient to allow purchases of that scale without the

ECB dominating the markets. But if it were in the trillions, the programme would almost certainly

have to include sovereign debt. We continue to believe that capital key-weighted purchases

would be the cleanest way of avoiding legal challenges, if this proved necessary.

Conclusion

The likelihood of a broad-based asset-purchase programme has declined following the package

of measures the ECB announced in June. We have revised our call accordingly and no longer

include QE in our central scenario. Still, as inflation is going to stay uncomfortably low, it will

continue to be talked about as an option. While we had forecast that the ECB would deliver a

range of policy initiatives in the wake of persistent downward surprises on inflation, key aspects

of June’s announcement, in particular on TLTROs, went further than we had been expecting.

Moreover, recent communication from the ECB highlights its high level of confidence that the

measures will have substantial effects.

We are not so convinced. We continue to see downside risks to the staff inflation projections

and believe there is a compelling case for doing more. The ECB’s willingness to launch QE in

the absence of a significant shock, however, appears to have diminished significantly.

Paul Mortimer-Lee & Ken Wattret

Time and reason would be

key to size and make-up

The longer the delay, thebigger QE would need to be

The bottom line



17 July 2014


Implementation of TLTROsThe four phases



This publication is classified as non-objective research

17 July 2014


The four phases

There are four distinct TLTRO phases:

- Phase I: Sep-14 and Dec-14 based on stock of qualifying loans.- Phase II: Mar-15 and Jun-15 based on existing trajectory of lending.

- Phase III: Sep-15 to Jun-16 based on trajectory of lending vs April 2015.

- Phase IV: Sep-16 mandatory repayment test based on cumulative lending.

Banks whose recent de-leveraging has outpaced their 12m average might want to use

their maximum allowance in Phase I, as they may not be able to beat the benchmark in

Phases II and III.

Banks which have recently experienced steep de-leveraging (eg Spanish) could find it

easier to borrow during Phase II than in Phase III.

We have split the eight available TLTROs that will take place from Sep-2014 to Jun-2016 into

four distinct phases (Chart 1), with the first two TLTROs that will take place in Sep-2014 andDec-2014 constituting Phase 1. For these two TLTROs we already know the maximum take-up

is roughly EUR 400bn (Table 1 shows amount per country), which is 7% of the outstanding pool

of eligible loans at the end of April 2014 (static snapshot).

The next two TLTROs that will take place in Mar-2015 and Jun-2015 constitute Phase 2. We

have put these two TLTROs in a group of their own for two reasons. They are distinct from the

first two TLTROs because they depend on the evolution of net lending from May 2014 to the

reference month of each TLTRO (Jan-15 for the Mar-15 TLTRO and Apr-15 for the Jun-15

TLTRO) versus a pre-defined benchmark, while the first two TLTROs depend on the

outstanding amount of loans at a specific point (April 2014). They also differ from the last four

TLTROs (Sep-2015 to Jun-2016) in the way their benchmark is estimated (Charts 2 and 3 show

the projected benchmarks for Spanish and Italian banks).

Chart 1: Four TLTRO phases Table 1: Take up of first and second TLTROs

Phase 1

Phase 2

Phase 3

Phase 4

DE 23.7%

FR 19.3%

IT 18.9%

ES 13.5%

NL 7.3%

AT 3.8%

BE 2.5%GR 2.4%

PT 2.1%

IE 1.9%

FI 1.7%

Others 2.8%

Euro Area 100%

TLTROs Eligible Loans (Apr‐14) TLTROs Takeup

97

5692

158

414

219

139

771

1099

1075

Eligible

Loans Pool

140

1350

110

120

House

holds

128

1468

107

114

765

1123

Non‐Fin

Corp.

116

904

87

96

122

605

863

836

373

163

98

117

5227

599

107

429

69

4331

Share

(%)

71

144

127

71

89

3866

TLTRO

Eligibility

(7%)

9.8

94.5

7.7

9.7

54.0

76.9

388

88

105

15.3

8.4

598

887

360

Loans for

Housing

104

1022

83

398.4

75.3

29.0

11.0

6.8

Source: BNP Paribas, ECB Source: BNP Paribas, ECB

Chart 2: Implied lending benchmarks for Spanish banks Chart 3: Implied lending benchmarks for Italian banks

8th7th6th5th

4th -2015Apr benchmark used for

TLTRO Jun-15

3rd -2015Janbenchmark used for

TLTRO Mar-15

2014Apr 7% of which is theallowance for 1st &

2nd TLTROs

600,000

650,000

700,000

750,000

800,000

850,000

900,000

phase 1

phase 2phase 3

Constant benchmarks

for TLTROs 5th to 8th

phase 4

8th7th6th5th

4th - 2015Apr benchmark used

for TLTRO Jun-15

3rd - 2015Janbenchmark used

for TLTRO Mar-15

2014Apr

7% of which is theallowance for 1st& 2nd TLTROs

1,020,000

1,040,000

1,060,000

1,080,000

1,100,000

phase 1

phase 2phase 3

Constant benchmarksfor TLTROs 5th to 8th

phase 4

Source: BNP Paribas, ECB Source: BNP Paribas, ECB

Phase 1: Sep-14 & Dec-14,

initial take-up is alreadyknown (up to EUR 400bn)

Phase 2: Mar-15 & Jun-15,depending on net lendingsince May 2014 but versusa dynamic benchmark




17 July 2014


Phase 2 TLTROs are different because, in estimating the benchmark, the ECB takes into

account the recent (May 2013 - April 2014) evolution of each bank’s net lending. If a bank has

been deleveraging aggressively during the 12 months leading up to April 2014, the average

monthly pace of this deleveraging will be used to extrapolate a projected net lending path from

May 2014 until April 2015. Therefore, a bank can continue deleveraging and still borrow morefrom the Mar-2015 and Jun-2015 TLTROs if its deleveraging pace has not been as steep as

that between May 2013 and April 2014. For banks that have not deleveraged between

May-2013 and Apr-2014 (unchanged or increased net lending), the benchmark is just the April

2014 outstanding amount of eligible loans (constant benchmark).

However, this extrapolated trajectory of net lending is not taken into account for the Sep-2015 to

Jun-2016 TLTROs for any bank, whether it deleverages or not. The rule is that, to borrow in the

last four TLTROs, net lending must be above the April 2015 projected data point (equal to the

actual April 2014 data point for non-deleveraging banks). In other words, the benchmark based

on the outstanding amount of eligible loans remains constant.

The direct implication of this methodology is that banks which have recently experienced a

steep deleveraging trend, such as the Spanish, could find it easier to borrow additional amounts(beyond the first and second TLTROs) in the third and fourth TLTROs than in the fifth to the

eighth (green line in Chart 1). This is especially true if the pace of deleveraging has slowed

compared with the last 12 month average. Moreover, banks whose deleveraging has outpaced

its previous 12 month average might want to use the maximum allowance in the first and

second TLTROs, as they could find it difficult to beat the benchmark in subsequent TLTROs.

Chart 4 shows the year-on-year percentage change in the TLTRO-eligible pool of loans across

different countries since January 2012. In some countries, such as Spain and France, there has

been a recent improvement in net lending while in others, such as Ireland and the Netherlands,

there has been a deterioration.

Mandatory early repayment in September 2016

In this section we analyse eligibility for borrowing additional amounts in the third to the eighth

TLTROs, and the circumstances under which a mandatory early repayment in September

2016 − two years before original expiry − can be forced (Phase 4). For simplicity we assume

there is only one top-up TLTRO facility in June 2015 (the fourth TLTRO), which will based on

reference net lending data of April 2015 as shown in Chart 5. We also assume that the

hypothetical bank under examination will top up the full amount it is entitled to (assuming that it

is) ie, 3 x (actual lending in April 2015 minus benchmark). We have constructed scenarios for

four hypothetical banks (defined by different colours in Chart 5) and for each scenario we

consider firstly whether there is eligibility for a top-up in June 2015 and, secondly, whether there

will be a mandatory early repayment in September 2016 and for what amount.

Chart 4: Annual % change in LTRO-eligible pool of loans Chart 5: Four lending scenarios

-20%

-15%

-10%

-5%

0%

5%

10%

GER

FRA

FIN

AUS

NET

BEL

ITA

SPA

POR

IRE

GRE

Source: BNP Paribas, ECB Source: BNP Paribas

Phase 3: Sep-15 to Jun-16,depending on net lendingbut versus a constantbenchmark (April 2015)

Deleveraging banks willhave to deleverage less inorder to be able to borrowadditional amounts

Implications of thebenchmark estimation forparticipating in TLTROs

Phase 4: Sep-16, bankscould face a mandatoryearly repayment if they arebelow the benchmark



17 July 2014


Market implicationsFX: No QE implies slower EUR depreciation, but stay short

Money market and ccy basis: Still ample excess liquidity

Core rates and inflation: ZIRP to keep core rates and breakeven

inflation low


Credit: No QE, no cry




17 July 2014


No QE implies slower EUR depreciation, but stay short

We have raised our EURUSD forecast targets modestly, to reflect the reducedprospect of QE.

We continue to expect the EUR to trade broadly weaker in H2.

We favour EURUSD and EURGBP shorts and recommend funding risk and carry

positions in EUR.

The reduced likelihood of the ECB announcing a QE programme implies a somewhat slower

path of EUR depreciation than previously anticipated. However, we continue to expect the

currency to trade with a weaker bias in the second half of the 2014 relative to the rest of the

G10 and most EM currencies, as the effects of the June rate cut continue to weigh. We are

making a modest adjustment to our EURUSD forecasts, raising the Q3 2014 target from 1.32 to

1.34 and the year-end 2014 target to 1.32 from 1.30. Our Q1 2015 target has been raised to1.30 from 1.28 but we continue to look for 1.26 by the end of Q3 2015.

While EURUSD is little changed from levels prevailing prior to the ECB’s June rate cut, the EUR

has weakened on a broader basis, losing about 1% on an effective exchange rate basis and

weakening sharply versus the GBP and the commodity bloc currencies. Moreover, even

EURUSD has declined about 2.5% from levels prevailing before the May ECB meeting, when

President Draghi sent a strong signal that rates would be cut in June. EURUSD’s lack of

downward progress since May is consistent with a generally weaker dollar prevailing over this

period, with USDJPY also trading lower.

Unlike the rate cuts delivered by the ECB in May and November of 2013, the policy action

announced in June succeeded in substantially lowering EUR money market rates. The

combination of a lower policy corridor, end to SMP sterilisation and plans for the TLTROsannounced in June finally managed to end the downward trend in excess reserves which had

been in place since late 2013, bringing eonia fixings close to zero and knocking 15bp off the

3-month Euribor fixing. As a result, EUR money market rates have fallen to near the bottom of

the G10 and the EUR has emerged as the most attractive funding currency for G10 and EM

carry trades, at a time when the low volatility environment is encouraging a scramble for yield.

Lower peripheral bond yields may also be discouraging inflows into eurozone bonds now,

allowing the broad basic balance to decline to zero in April on a 3-month basis.

The USD’s failure to gain ground versus the EUR (and other G10 currencies) over the past six

weeks is consistent with a loss of real yield support for the US currency. As Chart 4 below

We have raised our year-end EURUSD target to 1.32from 1.30

The EUR has weakenedsince June easing, thoughnot vs USD

EUR is now the mostattractive funding

currency for carry trades

Chart 1: EUR now the most attractive fundingcurrency for G10 carry trades Chart 2: Eurozone broad balance no longer in surplusthanks to bond outflows

Source: Macrobond, Bloomberg, BNP Paribas Source: Macrobond, Bloomberg, BNP Paribas

EUR has gained real yieldadvantage vs USD




17 July 2014


shows, US short-term inflation expectations (as implied by inflation swaps) have jumped since

the June FOMC meeting, outpacing the move higher in US front-end rates over this period. In

contrast, the June ECB easing has not succeeded in reviving confidence in the ECB’s capacity

to achieve its 2% inflation target over a two-year horizon.

Going forward, we see scope for the USD to regain the loss in real yield support experienced

over the past few weeks. The approach of Fed rate hikes in the second half of 2015 should

guide US nominal front-end rates steadily higher on a trend basis even as the Fed’s 2% inflation

target provides an anchor for US inflation expectations. And, while we don’t see scope for

eurozone inflation expectations to recover quickly, our rates strategy team notes that the

continued possibility of ECB QE operations should help keep a floor on eurozone inflation

expectations going forward, even as nominal rates remain low and anchored.

Trading implications

We see two sets of trading implications for the EUR in the second half of 2014 from the above

analysis:

Trade policy divergence: We continue to favour staying short EUR vs the GBP and the

USD as ECB policy diverges from that of the BoE and the Fed. The ECB’s indication

that QE is more likely if the EUR strengthens has created a perception of asymmetric

risk for the currency, and should mean continued interest in selling the EUR on rallies

vs these currencies.

Fund in EUR: The EUR should increasingly be viewed as an attractive funding

currency for carry plays into higher yield currencies. We expect the EUR to trend lower

vs the commodity bloc and higher yielding EM currencies during periods of stable and

healthy risk appetite. In the options market, the EUR should increasingly be priced to

correlate more with low-yield currencies like the JPY, and less with high-yielders like

the AUD.

Daniel Katzive

Real yields should moveagainst the EUR

Chart 3: EUR vs USD real yield differentials have movedin the EUR’s favour …

Chart 4: … because US/eurozone inflation expectationshave diverged

Source: Macrobond, Bloomberg, BNP Paribas Source: Macrobond, Bloomberg, BNP Paribas




17 July 2014


Money market & ccy basis: Still ample excess liquidity

TLTROs will lead to a smaller rise in excess liquidity with a slightly shorter duration

than would be the case with QE, but ample excess liquidity will remain.

The money-market curve therefore looks too steep to us.

The EURUSD cross-currency basis will not widen as much as with QE, but should still

reach -12bp in the 5y by end-2014.

Money market

The biggest difference between TLTROs and QE is the size and, potentially, the maturity of the

net cash injection (injection – repayments + expiring tenders): TLTROs alone are likely to lead

to a smaller rise in liquidity with a slightly shorter maturity than in the case of QE.

Part of the reason for the smaller net injection of liquidity is that a significant part of the take up

(gross injection) of TLTROs will be accompanied by repayments on the LTROs. The ECB is

targeting a maximum EUR 1trn overall take-up at all eight TLTROs. If we make the extreme

assumption that this EUR 1trn is a substitute for all other open market operations, this would

lead to a net rise in liquidity of EUR 455bn in the current environment. With current excess

liquidity at around EUR 135bn, this would boost excess liquidity to EUR 590bn, the same level

as in early 2013, ahead of the first repayments on the 3y LTRO. At that time, the eonia/deposit

facility spread was 0.08%.

When it comes to the maturity of the injected liquidity, the ECB’s securities markets programme

(SMP) portfolio had a higher average maturity than the 3y LTRO. A year after the ECB stopped

purchasing assets under the SMP, the maturity of this portfolio was 4.3y, dropping to 3.9y after

two years. This suggests an average maturity longer than 4.5y and shorter than 5y when the

ECB stopped purchasing. Compared with the 4y TLTRO, QE would therefore seem to offer

longer term liquidity, although the difference is relatively small.

However, whether the ECB implements QE or not, there will be little impact on the money

market curve. The high level of excess liquidity will keep the front end flat and, as the

conditional benchmarks set for the TLTROs are easy to beat, this should last until the end of

2016 and probably longer (the mandatory repayments are likely to be very small). The curve

therefore looks too steep, at least until the end of 2016. The 2y3m OIS is at 0.17%.

Trade idea: Receive 2y3m OIS

However, a QE programme would see tighter OIS/BOR spreads across the board and, as a

result, OIS/BOR spreads could be slightly paid. But, as the ECB is providing ample liquidity at a

cheap price for a long time (full allotment at a fixed rate until the end of 2016), BORs should notrise significantly. OIS/BOR spreads have the potential to rise slightly above 15bp but we don’t

see them moving much further.

EURUSD x-ccy

In the absence of QE, the EURUSD x-ccy basis will probably not widen as much as we

previously thought (our call was for a rewidening of the 5y spot basis towards -15bp and

possibly further in the case of QE). However, we still expect a widening and still like receiving

the basis.

One of the reasons for the less-than-expected widening is the smaller extension of liquidity

expected from the TLTROs compared to a QE programme, which implies a lesser cheapening

of the EUR relative to the USD, reflected by a basis which will also be less negative.

Another reason is that the expected shutdown of USD issuance by European SSAs is less likely

to materialise in the absence of QE. In a QE environment, the lack of USD issuance by

European SSAs, which are heavy users of the cross-currency market, was critical to our ‘-15bp




17 July 2014


and beyond’ call. Without it, the widening of the cross-currency will be more limited as interest in

paying the basis will be smaller.

However, there are still reasons to expect a further widening of the x-ccy basis from current

levels, even without QE.

First, one of the consequences of the absence of QE is that we are less bullish on peripherals

as uncertainty and volatility pick up on the back of the fading of QE expectations. Episodes of

risk aversion cannot be ruled out in this environment. As a result, the year-to-date decline in the

Italian sovereign CDS spread is likely to continue to slow and the likelihood of a breakthrough of

the four-year low reached on 9 June has diminished, which means the x-ccy basis has less

room to tighten.

Second, even if the expected pickup in excess liquidity from TLTROs is not as large as it would

have been with a QE programme, it will still be significant enough to trigger further widening of

the x-ccy basis from current levels. We expect the take up at the first two TLTROs to be

significant, especially after the ECB released more details of how they will work. For instance, if

excess liquidity rises to EUR 350bn, this would be consistent with a 5y x-ccy basis of -12bp in

our model, all other things remaining equal.

In the meantime however, the volume of excess liquidity is likely to decline by the end of the

summer as repayment of the 3y LTROs continues, and we think it could decline to EUR 90-

100bn in the run up to the first TLTRO in September if the pace of weekly repayments remains

at around EUR 4bn. In this case, the fair value of the 5y basis would fall back towards -7.5bp in

our model, all other things remaining equal, or closer to -6bp should the market move into risk-

on mode at the same time.

To understand the relationship between excess liquidity and the cross-currency basis, keep in

mind that TLTROs could also, to some extent, be used as a cheap USD funding synthetic tool:

a European bank could borrow euros from the ECB through the TLTRO and then swap the

proceeds back to US dollars using the x-ccy basis swap market. The cost of this operation

would be around $L-4bp (ignoring execution costs, haircut at the ECB etc), which in most casesis much less than through the bond market (Deutsche Bank sold a 3y USD bond in May at

$L+58bp). With this operation European banks receive the basis, thus pushing the basis wider

(ie, into more negative territory).

Furthermore, whether QE takes place or not, after the significant fall in EUR yields there is an

incentive for foreign entities to issue in EUR and swap back to their domestic currency through

the x-ccy basis swap market as the cost of funding is looking increasingly attractive. A

protracted zero interest rate policy in the eurozone would therefore support a widening of the

basis led by a pickup in interest in issuing in EUR and receiving the basis. However, we

acknowledge that under QE, the volume of interest in such operations would probably be more

significant, because in that environment foreign bonds would have more room to tighten due to

the rebalancing effect. That, together with the potential shutdown in USD issuance by European

entities spelled out earlier, was also critical to our ‘-15bp and beyond’ call.

Overall, we keep receiving the basis – even in the absence of QE – as the TLTROs are set

to push the basis further into negative territory from September. However, we would not

enter the trade now as it has room to tighten over the summer, and we lower our target

on the 5y spot basis to -12bp from -15bp+ initially. Enter the trade at -6bp.

Patrick Jacq and Camille de Courcel




17 July 2014


Core/semi-core rates and inflation: ZIRP to keep ratesand breakeven inflation low

A zero interest rate policy (ZIRP) implies low volatility and low core rates: we expect

the 5-year and 10-year to outperform further on the curve.

Semi-core and SSA spreads should benefit from a ZIRP; we continue to forecasttighter SSA and semi-core spreads.

Without QE, the market will remain sceptical that inflation will revive, keepingbreakeven inflation and core nominal rates under downward pressure.

Core rates: Low rates for longer

The ECB's apparent preferred policy stance of strong long-term forward guidance without QE

means low volatility in core rates and uncertainty over the volume of liquidity to be injected intothe system. Both should keep core rates lower than would have been the case under QE.

One of the key differences between QE and the TLTROs is that the volume of liquidity that will

be injected ultimately relies on the banks’ willingness and ability to expand balance sheet, and

less so on the ECB’s. It could therefore end up being less than the ECB envisions.

Another difference is that, in the absence of QE, the so-called ‘announcement effect’, consisting

of a bond market sell-off as inflation expectations pick up as soon as it becomes clear that the

ECB is about to embark on QE, will not materialise.

Hence, TLTROs instead of QE mean low rates for longer; the 20bp fall in the 10y Bund yield

since the ECB announced the TLTRO is a good illustration of the difference between the two

policies.

Thus we expect further 2s5s flattening and the 10s to outperform on the curve, as

investors search for yield in an environment of low rate volatility and subdued inflation

expectations.

Semi-cores and SSAs: A protracted ZIRP environment is positive for spreads

For semi-core and SSA spreads, the change in expectations regarding the ECB policy outlook

will have little impact on the spread tightening we previously forecast.

In a low rates environment for longer, the chase for yield is set to continue. Against this

backdrop, SSAs and semi-core EGBs look attractive as they offer yield pickups to benchmark

bonds in exchange for a limited risk extension (semi-core EGBs) and/or in exchange for some

liquidity give-up (SSAs). A protracted ZIRP environment is especially positive for SSAs and

semi-core EGBs when the 10y Bund yield is at such a depressed level: with a 10y Bund yield at1.20%, any bond with a similar credit and offering 20-30bp pickup looks attractive.

Indeed, since the last ECB meeting, 5-10y EIB, EFSF and KfW have outperformed Germany by

4bp. Crucially, this outperformance has taken place despite the market being back in risk-off

mode, as illustrated by the heavy sell-off seen in peripherals. It has also taken place at a time

when SSAs usually underperform Germany as a result of their strong relationship with the Bund

ASW, which typically widens between mid-June and late-July because of the seasonal collapse

in net supply in the eurozone (note that this year we chose not to enter this seasonal trade in

light of the ECB June announcement because we expected increased appetite for SSAs). So

SSAs’ performance in this environment demonstrates a particularly strong appetite for them.

The post-ECB performance of semi-core EGBs has been less pronounced but this is

unsurprising after their significant performance achieved in the year-to-date.

Overall, we think QE could have had more power in terms of spread reduction – although

looking at recent pricing action it is hard to believe – notably because of the rebalancing effect

as far as SSAs are concerned. But a protracted ZIRP environment is still positive for semi-core




17 July 2014


EGBs and for SSAs, for the reasons stated earlier. The main difference between QE and the

TLTROs will therefore probably lie more in terms of the amount of time it will take before our

various targets are reached, rather than the targets themselves, as there is more uncertainty

lying ahead than there would have been with QE: uncertainty regarding the amount of take up

at the TLTROs and their use, and uncertainty with regard to the bond market in general, as theECB is a potential big buyer staying on the sidelines, leaving the market more vulnerable to

episodes of risk aversion.

To conclude, we are keeping our target on semi-core unchanged: Our 10y OAT/Bund spread

target is at 25bp.

Inflation: ECB balance sheet expansion should keep 5y5y breakevens in a tight range

5y5y EUR HICPxt breakevens are below 2.10% - close to their lows. Unlike on previous

occasions when the ECB has embarked on unconventional easing, inflation breakevens have

not collapsed (because of a crisis) but rather have been drifting lower since late 2012. Thisgradual but protracted decline in eurozone breakevens is more consistent with a structural re-

pricing of inflation expectations. This may be partly responsible for the lack of reaction to the

ECB’s June measures and the announcement of TLTROs.

In the US, 5y5y forward breakevens rose by around 30bp on average in response to the Fed

announcement of QE via large scale asset purchases (LSAPs). During QEI (2009) and QEII

(from 2010), the dollar effective exchange rate depreciated by 10%+, helping to stimulate

inflation and at the very least avoiding deflation. Whilst we continue to expect a lower EURUSD

from USD strength as the US undergoes macroeconomic and policy normalisation, the lack of a

protracted decline in the EUR following the ECB’s June meeting may cap any upside for

inflation breakevens.

With eurozone HICP Ex-tobacco running at the low level of 0.4% y/y, the inflation market is

waiting for evidence of increasing inflationary pressure. Our economists don’t expect a pickup in

EUR inflation above 0.5% until Q4. In the absence of any support from inflation data, 10y

inflation breakevens are likely to stay low and not volatile. Despite not entering QE directly, the

potential for a significant expansion of the ECB balance sheet should be enough to keep 5y5y

EUR HICPxt breakevens above 2.00% - effectively putting a floor on longer dated inflation

expectations.

Chart 1: SSAs compressed further in July Chart 2: Semi-core compressed sharply post June-ECB

20

25

30

35

40

45

50

55

15

20

25

30

35

40

Feb 14 Mar 14 Apr 14 May 14 Jun 14 Jul 14

KfW Jan-20 Inverted Bund ASW (bp) EIB Jan-24 (RHS)

SSA spreads to Germany (bp)

June ECB

July ECB

sharp tighteningin spite of risk-off

sessions

15

20

25

30

35

40

30

35

40

45

50

55

60

65

70

75

Jan 14 Feb 14 Mar 14 Apr 14 May 14 Jun 14 Jul 14

10y BGB 10y OAT 10y RAGB (RHS)

Semi-core spreads to Germany (bp)

June ECB

July ECB

Source: BNP Paribas Source: BNP Paribas




17 July 2014


Without underlying volatility in the European inflation market (or the HICP itself), we keep our

focus on tactical trading opportunities around seasonality and carry. The front end remains

exposed to further repricing of negative carry which, combined with index extensions and the

macro picture should keep the inflation curve steep in the eurozone. We have reversed our key

QE-based recommendation (long EUR vs US breakevens) given the rise in US CPI inflationabove 2% y/y and the strong positive carry from being long US inflation through the summer.

Camille de Courcel and Shahid Ladha

Chart 3: 5y5y US & EUR Inflation swap fwdsvs key unconventional policy

Chart 4: Currency (effective EUR) vs core inflationand 5y5y EUR HICPxt forwards

‐15.0

‐10.0

‐5.0

0.0

5.0

10.0

15.0

20.0

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Jan ‐06 Jan‐07 Jan‐08 Jan‐09 Jan‐10 Jan‐11 Jan‐12 Jan‐13 Jan‐14 Jan‐15

5y5y EUR HICPxt Inflation fwd

Core HICP % y/y

EUR Effective exchange rate (9m lag), RHS





17 July 2014



The greatest change in our forecasts resulting from the reduced probability of QE is

in peripheral sovereign spreads.

TLTROs differ from both 3y LTROs and QE in three important ways:

- The size and use of the borrowed funds from TLTROs will remain uncertain,

providing a less transparent exit point for investors who have been purchasing

peripherals in anticipation of QE.

- TLTROs reinforce the link between sovereigns and banks whereas QE could

have weakened them, setting the ground for a non-zero risk weighting on

sovereign bonds.

- The absence of a direct ECB bid for peripherals should lead to higher spread

volatility and so to a higher risk premium in peripheral spreads.

We now anticipate that 10y Spanish and Italian spreads to Bunds will end 2014 at+150bp (vs our prior expectation of +100bp). Furthermore, as we expect higher

volatility given the lower probability of QE, we do not see peripheral spreads as cheap

enough to buy below 180bp.

We expect 3y peripheral spreads to be better-supported than the 10s, due to the

nature of TLTROs. We now target +60bp at end-2014 (vs our +40bp prior expectation)

TLTROs vs QE: A different outlook for sovereign spreads

While the anticipated effect of the TLTRO programme may differ little from the anticipated effect

of QE in terms of its effect on liquidity, it does have substantially different effects on peripheral

sovereign bonds (see Box 2: TLTRO market impact versus 3y LTRO and QE).

For peripheral sovereign spreads, what are the implications?

1. Reduced probability of imminent QE reduces anticipated spread narrowing

We had expected QE to mean a large (eg EUR 30-40bn/month) price-insensitive bid from the

ECB for sovereign bonds, with the ECB purchases distributed across maturities (probably in the

0-10y) and across sovereigns (in line with ECB capital key weights).

Compared to this baseline expectation, the TLTRO programme raises uncertainty for sovereign

assets in all these vectors ie, size and distribution across sovereigns (depends on banks’

qualifying loan growth and asset preference), price sensitivity (banks may wait to buy if they

think yields are rising) and maturity (how much curve risk banks would wish to take versus 4-

year ECB money).

Conclusion: This adds up to a significant rise in uncertainty for holders of peripheral sovereign

bonds compared to our previous base case of full-scale QE and implies that our peripheral

sovereign spread forecasts should be revised up considerably.

2. Strong forward guidance that ZIRP will persist is still in place: Still good for spreads

Compared to QE, the TLTRO programme provides similarly strong forward guidance that the

ECB’s ZIRP will remain in place for several years. The experience of Japan is that even without

QE, ZIRP does reduce volatility and bring down all credit spreads, notably in shorter maturities.

Conclusion: the ECB’s explicit and implicit (because of the term of the TLTROs) ZIRP forward

guidance is supportive of sovereign spreads, but no more so than would have been the case

under our previous base case of full-scale QE.




17 July 2014


3. Higher spread volatility due to greater uncertainty implies wider spreads

Spread volatility in the Spanish and Italian 10y has fallen over the past 12 months (Chart 1) to

its lowest levels since 2011 (by a concomitant fall in spreads). But expected spread volatilityshould be higher under the TLTRO programme than under a QE programme for two reasons:

The increased uncertainties regarding the size, distribution, persistence and price

sensitivity of demand under the TLTRO programme compared to QE; and

Individual event risks, as they occur, should be expected to have a larger impact on

market pricing under the TLTRO programme than QE because the implied backstop

bid (and credit backstop) from the ECB is weaker.

But spread volatility is unlikely to return to the extreme levels seen during summer 2011 –

summer 2012 in our view, because

There are now support mechanisms in place which were not present before (outright

monetary transactions (OMT), TLTROs, strong forward guidance and the possibility

that the ECB will still eventually adopt QE);

Sovereign credits have generally become less vulnerable, with ratings generally

improved, or at least no longer worsening; and

Banks are better capitalised.

Conclusion: Higher expected spread volatility should lead to demand for a higher risk premium

in sovereign spreads than compared to our previous base case of full-scale QE, but not as high

as during the crisis period leading to the OMT announcement. The incremental risk premium

should be higher in longer than shorter maturities, due to the existence of TLTROs. This implies

that our sovereign spread forecasts should be revised up, particularly in longer maturities.

Chart 1: 10y ITA/GER spread’s annualised volatility (1m, 3m, 6m)

Source: BNP Paribas

4. Supply and demand

Supply and demand considerations are still broadly positive, although of course not as positive

as they would have been under our previous base case of full-scale QE.

On the supply side: Spain and Italy have already completed more than 70% of their planned

2014 issuance.

On the demand side: Since July 2013, non-bank ownership of Spanish and Italian bonds has

increased significantly, as non-bank buying has greatly outstripped banks’ purchases.




17 July 2014


Investors other than domestic banks have bought EUR 135bn Italy and EUR 96bn Spain (net)

since June 2013 (Chart 2). Should these non-domestic bank buyers decide to take some profit,

there will be considerable secondary market supply. On the other hand, the TLTROs clearly

offer the banks cheap funding to absorb some of that potential selling. If the Spanish and Italian

banks took all the funding available in the first two TLTROs and invested it all in sovereign debt,they could buy some EUR 75bn Italy and EUR 55bn Spain.

Chart 2: Cumulative purchases of Italian and Spanish debt by investors other thandomestic banks (EUR bn)

Source: BNP Paribas

Conclusion: supply and demand considerations are less favourable to peripherals than

compared to our previous base case of full-scale QE this year, but unless non-bank owners turn

into sellers, the supply and demand picture remains favourable.

New peripheral spread forecasts

In the absence of QE, the uncertainties for peripheral spreads are greater and spread levelsharder to forecast.

We do expect their path in the coming quarters to be much more event-driven and volatile than

would have been the case under QE. Furthermore, because spread volatility and the level of

spreads are closely correlated, there is a danger that spread widening could be self-reinforcing.

Therefore, we believe that investing in peripherals will depend much more on valuation (spread

vs carry) than was previously the case:

If 10y spread volatility remains around the levels to which it has recently rebounded, we expect

10y Spanish and Italian spreads to end 2014 at around present spread levels of 150bp. But at

present levels of spread volatility we would not consider Spain and Italy cheap unless spreads

rose to around 180bp.

For 3y spreads, as explained above, we see less chance of higher volatility. If 3y spread

volatility remains around current levels, we expect 3y Spanish and Italian spreads to end 2014

at 60bp, marginally tighter than current levels. We see less prospect of a rise in spread volatility

in sub-4y peripherals, so we recommend remaining long 3y Spain and Italy at present spread

levels versus Germany.

Laurence Mutkin & Ioannis Sokos




17 July 2014


Box 2: TLTRO market impact versus 3y LTRO and QE

The size and use of the borrowed funds from TLTROs will remain uncertain, providing a less transparent exit point for investors who have

been purchasing peripherals in anticipation of QE.

TLTROs reinforce the link between sovereigns and banks whereas QE could have weakened them, setting the ground for a non-zero riskweighting on sovereign bonds.

We anticipate more volatility in peripherals, which could lead to investors demanding a higher premium in order to keep buying peripheral

bonds given the lack of a clear backstop mechanism in the near term.

TLTROs vs 3-year LTROs – market impact

There are some key differences and similarities between TLTROs and LTROs. The main difference was supposed to be the fact

that the former target the real economy, but the ECB has attached few conditions to TLTROs, leaving significant room for a

different use of the borrowed amounts. The carry trade might not be as attractive as it was in early 2012, but it is still a profitable

trade given the very cheap funding rate of 25bp. Another key difference is the full allotment, which is not yet known in TLTROs.

There is a maximum allowance, which is already known for the first and second TLTROs and which for subsequent TLTROs will

depend on net lending evolution. Banks will therefore not be able to borrow as much as they want and, on top of this, they will

have to meet certain criteria (beating the benchmark) in order to keep the borrowed amounts until September 2018 and not facea mandatory repayment order in September 2016.

Table 1 shows that, for the first and second TLTROs, only 32.4% of the total amount will be allocated to Italian and Spanish banks

(assuming full take-up by all), whereas this percentage was 53.5% in the 3-year LTROs. Moreover, the maximum allowance in the

first two TLTROs is roughly EUR 195bn short of the current outstanding of the 3-year LTROs for Italian and Spanish banks, on

aggregate. In terms of market implication, the current environment is so different to early 2012 − with Greece’s debt restructuring

and subsequent elections, the ECB’s outright monetary transactions and the situation for European banks at that time − that a

comparison with the 3-year LTROs of early 2012 is meaningless. The only impact we can predict is that the short end of peripheral

curves should be supported more than longer maturities − potentially leading to a steepening of the curve. Chart 1 shows the yield

change among different maturity buckets in Italy and Spain around the time of the 3-year LTROs in late 2011–early 2012.

TLTROs vs QE – market impact

Over the past few months the market has started pricing in the probability of QE, leading to a strong compression in peripheral

spreads across the curve, but this case has weakened since the central bank’s June and July meetings. If QE were to be

implemented, it would have to wait until an assessment of the impact of the TLTROs has been made, most probably towards

the end of H1 2015. At this point, the important question is whether or not the TLTROs and the other recent ECB

announcements are strong enough to keep peripheral spreads at their recent low levels.

We look firstly at the potential size and country breakdown in the case of QE versus TLTROs. Our initial estimate for a QE

programme was EUR 400bn in its first stage, although there was talk later of EUR 1trn. This is similar to the EUR 400bn maximum

initial take-up in the first and second TLTROs and the EUR 1trn that ECB President Draghi mentioned for all TLTROs up to June

2016. The country breakdown is also roughly similar, as shown in Table 2, since the ECB capital key is not far from the weighting

according to the outstanding amount of TLTRO eligible loans. However, while in the case of QE we would know the total amount ofeach country’s debt being bought by the ECB in advance, this is not true for the TLTROs. There is uncertainty both with respect to

the initial take-up (we only know the maximum allowance) and to any allowance in subsequent TLTROs (the third to the eighth).

Table 1: Allocations differ between TLTROs and LTROs Chart 1: Impact of 3-year LTROs in 2011 and 2012

DE 23.7% 7.4% 16.4%

FR 19.3% 13.7% 5.6%

IT 18.9% 25.0% ‐6.1%

ES 13.5% 28.5% ‐14.9%

NL 7.3% 0.0% 7.3%

AT 3.8% 1.4% 2.4%

BE 2.5% 3.4% ‐1.0%

GR 2.4% 12.3% ‐9.8%

PT 2.1% 2.2% ‐0.1%

IE 1.9% 1.5% 0.4%

FI 1.7% 0.4% 1.4%

Others 2.8% 4.3% ‐1.5%

Euro Area 100% 100% 0%

TLTROs Takeup TLTROs vs 3y LTROs vs outst. LTROs

457

0

35

20

1

170

155

0

4

10

Share

(%)

TLTRO ‐

LTRO (%)

LTROs

Outst.

10

50

15.2

3.6

43.9 2

0.0

14.4

35.0

125.0

22.0

Total

LTROs

75.0

140.0

254.7

290.0

1.4

529.5

10.6

1018.7

6.5

65.0

170.0

50.0

139.0

2nd

LTRO

Take‐Up

23.0

40.0

10.0

14.0

120.0

90.0

115.7

1st

LTRO

Take‐Up

12.0

35.0

5.2

8.0

2.2

489.2

33.2

7.9

60.0

Share

(%)

TLTRO

Eligibility

(7%)

9.8

94.5

7.7

9.7

54.0

76.9

15.3

8.4

398.4

75.3

29.0

11.0

6.8

‐26.6

‐12.3

5.8

9.0

‐58.6

TLTRO ‐

Existing

LTRO

84.5

26.9

‐94.7

‐101.0

29.0

11.3

‐0.2

9.7

-450

-400

-350

-300

-250

-200

-150

-100

-50

0

3ySPA/GER

5ySPA/GER

10ySPA/GER

30ySPA/GER

3yITA/GER

5yITA/GER

10yITA/GER

30yITA/GER

Spreads' change from 8 Dec 2011 to 1 Mar 2012





17 July 2014


This uncertainty makes the exit strategy of investors who bought peripherals in anticipation of QE less transparent. Obviously

we do not know whether investors have bought peripherals in anticipation of QE or because of a broader improvement in the

fundamentals of each country and the need for extra yield in a zero interest rate policy world. However, data have shown that

investors other than domestic monetary financial institutions (MFIs) have increased their participation in peripheral markets

since last summer. Chart 2 shows the cumulative monthly purchases of Italian and Spanish debt by investors other than

domestic MFIs. This group includes both non-resident investors and all other domestic investors apart from domestic banks. It

shows the relatively heavy market positioning which has been long the periphery for a while now. Charts 3 and 4 show the

impact of ECB meetings on peripheral yields and spreads across different maturity buckets.

As shown in the charts above, peripheral spreads and yields have compressed between ECB meetings, except in May when

spreads widened. However, since the July ECB meeting, peripheral yields and spreads have both risen on the back of fading

expectation of imminent QE. Note there was no such reaction to June meeting, because back then it was unclear if TLTROs

might in some way replace QE or add to its impact. However, the ECB’s rhetoric at the July meeting pointed in a different

direction; QE is still on the table but only after an assessment of the effect of the TLTROs.

In summary, we believe that the impact of TLTROs on the market differs from that of QE. There is a lot of uncertainty around the

size and the timing of support for peripheral bonds under TLTROs, which would not be the case under QE. The recent market

pricing in of QE has reversed recently, and the anticipation of QE was one of the reasons for the market positioning long in

peripherals. The recent increase in volatility has only just begun to be compensated by higher yields and the lack of imminent QE

could lead investors to demand further protection. The fact that QE is still on the table could cap yields, but we will still revise our

targets for the end of 2014 assuming no QE during this period.

Table 2: Similar allocationsin TLTROs and QE

Chart 2: Net cumulative purchases of peripheral debt byinvestors other than domestic MFIs since 2012

DE 23.7% ‐13.8 38.9 2.9% ‐0.6% 3.5%

FR 19.3% ‐4.4 23.9 2.2% ‐1.3% 3.5%

IT 18.9% 3.8 9.8 0.9% ‐2.5% 3.4%

ES 13.5% 6.5 ‐69.9 ‐9.1% ‐11.8% 2.7%

NL 7.3% 6.2 1.9 0.5% ‐3.0% 3.4%

AT 3.8% 4.2 5.1 2.3% ‐1.2% 3.5%

BE 2.5% ‐4.1 4.9 3.5% 0.2% 3.3%

GR 2.4% ‐1.5 ‐3.4 ‐2.5% ‐5.8% 3.3%

PT 2.1% ‐1.6 ‐6.1 ‐5.1% ‐8.2% 3.1%

IE 1.9% 1.4 ‐6.3 ‐5.7% ‐8.8% 3.0%

FI 1.7% ‐0.4 3.4 3.5% 0.5% 3.0%

Others 2.8% 2.0

Euro Area 100% 2.2 0.04% ‐3.35% 3.39%

Implied

Change

TLTROs Takeup vs QE Top‐up TLTROs

Implied

Net

Lending

May‐14

to Apr‐15

Lending

May‐13

to Apr

‐14

10.0

6.4

7.2

9.0

400.0

TLTRO ‐

QE (bn)

EUR 600bn

Top‐up

TLTROs

142.3

115.9

113.3

81.3

43.6

23.1

14.7

14.7

12.6

11.6

10.3

16.6

600.0

QE EUR

400bn

108.3

81.3

71.4

47.5

22.8

11.1

13.9

11.2

Share

(%)

TLTRO

Eligibility

(7%)

9.8

94.5

7.7

9.7

54.0

76.9

15.3

8.4

398.4

75.3

29.0

11.0

6.8

-100

-80

-60

-40

-20

0

20

40

60

80

100

120

01-12 03-12 05-12 07-12 09-12 11-12 01-13 03-13 05-13 07-13 09-13 11-13 01-14 03-14 05-14

Net Cumulative purchases of peripheral debt by investors others than

Domestic MFIs since Jan 2012 (EUR bn)

Italian Debt

Spanish Debt


Chart 3: Average SPA/ITA spreads vs Germany changeper ECB meeting

Chart 4: Average SPA/ITA yields change per ECBmeeting

-110

-100

-90

-80

-70

-60

-50

-40

-30

-20

-10

0

10

20

3y 5y 10y 30y

Average ITA/SPA Spreads' changes since 20 Feb

Post July ECB Post June ECB Post May ECB

Post April ECB Post March ECB 20 Feb to March ECB

-110

-100

-90

-80

-70

-60

-50

-40

-30

-20

-10

0

10

20

3y 5y 10y 30y

Average ITA/SPA Yields' changes since 20 Feb

Post July ECB Post June ECB Post May ECB

Post April ECB Post March ECB 20 Feb to March ECB





17 July 2014


In terms of Total Returns the absence of QE should be more beneficial to duration risk

(read longer maturity IG credit) at the expense of credit risk (read shorter maturity HY

credit). The benefit to duration risk would come via a bull flattening pressure on the Bund

curve, given that the lack of QE could push expectations for inflation to revert towards its

2% target further out in time. Two factors that could counteract this are: (i) any potentialbear steepening in real rates (but less likely if growth momentum keeps lagging); and (ii)

the fact that the 2-10y Bund curve is already trading just 2bp wider to its five year low of

116bp.

The Total Return performance across credit indices over the past couple of weeks has already

started to reflect this change in dynamics in favour of duration risk, see Chart 2, although the

flight to safety on the back of BES/ESF has contributed to this. Notably, Xover has given up

some of its recent outperformance vs. IG cash across currencies, with the performance gap

between Xover and € IG Cash, for example, narrowing from +c.3% shortly after the ECB

meeting on 5 June to +c.1.5% currently. € HY Cash has also given up some of its ytd

outperformance recently and now lags € IG Cash by over one point (3.8% vs. 5%). Under a ‘no

ECB QE’ regime we could likely be faced with the prospect of comparable Total Returns in both

IG and HY € credit in 2014, as the carry component over half a year would take both to a fullyear return of c.6% (if we are to assume no further tightening in credit spreads and ignoring the

curve rolldown).

In respect to CDS spreads under a ‘no ECB QE’ scenario, we would also expect a moderate

spread tightening and spread compression. This does not alter our expectation for iTraxx Xover

to outperform iTraxx Main, Sen Fin to outperform Main and Main to outperform CDX IG, but this

outperformance is bound to be more moderate. For example, under an ‘ECB QE’ scenario we

could envisage Main trading inside 50bp (e.g. 48bp) and Sen Fin well inside Main (e.g. 42bp) to

be consistent with a 10y Bono/BTP spread of 100bp over Bunds. Under a ‘no ECB QE’

scenario, however, 10y Bono/BTP spread would be at 150bp over Bunds and the analogous

levels for iTraxx would be mid/high 50s for Main (e.g. 57bp) and mid 50s for Sen Fin (e.g.

56bp).

Banks incentivised to use the TLTRO to the maximum

A key difference between QE and TLTRO in terms of impact on asset prices could be the size

and the timing of each programme. If the ECB were to announce a broad based asset purchase

programme, they would be likely to specify the timing of its deployment and the amounts

involved, thus giving certainty to the market. However, the aggregate amount of the TLTROs

cannot be known at the outset, giving rise to uncertainty given that the second phase

commencing in March 2015 would be highly dependent on net lending. Therefore, while the

TLTRO take-up will be incremental and uncertain, in the case of QE, the market would benefit

more from an announcement effect that comes with more clarity.

Despite these differences, we try here to estimate the potential TLTRO take-up. We believe that

banks will have an incentive to maximise their allowance for the TLTROs for the following

reasons:- No stigma, given the conditionality of Private Sector lending.

- 4y term funding at 25bp is very attractive.

- Banks can continue with the particularly attractive sovereign carry trade given its 0% RW.

- Banks in the periphery that are still dependent on the 3Y LTROs can refinance.

- The Central Banks will put pressure on the banks to tap the TLTRO.

President Draghi mentioned that the overall take-up could reach a maximum of €1tn. We

assume that this corresponds to €400bn in the first phase in September and December 2014

(i.e. the full allowance of 7% of existing Private Sector loans) and €600bn in the second phase

starting in March 2015 (this suggests €600bn/3= €200bn of additional lending over and above

the benchmarks, i.e. a strong 3.5% annual growth in total private lending across the eurozone),

well above the initial estimates of €150-300bn by our Banks Sector Specialists. For the

conditional TLTROs, while beating the benchmark of minus 3.3% 12-month growth in private

lending should not be difficult over 24 months, the actual take-up may be lower than the figure

suggested by President Draghi. For more details on our views on TLTROs we refer readers to




17 July 2014


the marketing material published by our Sector Specialists Gildas Surry and Geoffroy de

Pellegars: TLTROs for banks: no more stigma and Tweaked LTROs.

The EBA data from the EU-wide 2013 Transparency exercise indicates that 73% of banks (from

a representative subsample representing 61% of the sector) have reduced their lending from

December 2012 to June 2013. We can extrapolate this trend into April 2014. If we then assume

that these ‘deleveraging banks’ will just stop reducing their lending by keeping it flat from April

2014 onwards, they would be entitled to €191bn of TLTRO funding in the last of the six

additional allowances. We can also model that the lending banks (27% of this subsample)

would continue lending at the same pace and that would give them €110bn of TLTRO funding.

The total (€301bn) for 61% of the sector would suggest an overall €492bn of take-up in the

additional TLTROs for all eurozone banks.

Will the TLTROs lead to a substantial increase in lending?

There will be a lot of scrutiny on how lending evolves as the banks tap the TLTROs. The

average benchmark (net lending for one year until end of April 2014) of minus 3.3% leaves

ample room for improvement, nevertheless, certain factors could hinder a significant increase in

lending:

- The banks argue that they need more demand for borrowing from ‘solvent‘ credits.

- The economy remains vulnerable, especially in peripheral countries and thus banks will be

wary of creating the next ‘wave’ of NPLs.

- Lending to corporates, especially lower-rated or unrated corporates including SMEs,

remains capital intensive.

- Banks, especially weak banks (a few of those being in the periphery) continue to see

mounting pressure in terms of capital requirements. For example, the AQR/Stress Tests

are leading to more banks cleaning up their balance sheet, further deleveraging and higher

capitalisation. We calculate that €33bn of equity was raised by European banks year-to-

date in 2014, on top of €29bn of AT1 issuance. In a similar vein, the anticipation of a higher

minimum requirement for the leverage ratio (from 3% to potentially 4%) also acts as a

deterrent to lending.

- It will take some time before the reform of the ABS framework can effectively help create

some risk transfer and capital relief for banks. Joint proposals from the ECB and BoE are

heading in the right direction, but this will take time to implement.

Furthermore, the key aim for European authorities was to find a solution for the lack of funding

to SMEs. However, the benchmark could be met by lending to large corporates or consumers,

rather than SMEs. We were surprised that the TLTRO was not more targeted to SME lending.

The reason could be that defining what is an SME is tricky, e.g. an SME in Germany is not the

same size as an SME in Spain. The picture on lending could also differ significantly from one

country to another. This means that we could see lending improve more in the core countries

than in peripheral countries.

That said, SMEs stand as the most profitable lending segment to rebuild net interest margins ina low rate environment, improving earnings for banks and thus generating capital internally. We

would expect banks to guide towards a gradual impact on SME lending while the demand for it

continues to increase slowly. Also, without banks significantly increasing lending, banks will

fund each other more cheaply in a low rate and cheap TLTRO environment.

So far, the banks are still working on their numbers to assess their 7% allowance. Some banks

have already indicated that the TLTRO could be attractive, such as KBC at its investor update

on 17 June. Erste Bank in Austria said on 7 July, that the TLTRO might be a very good source

of funding and that it will look into it, even though it would be a small contribution. At the country

level, Bank of Italy Governor Ignazio Visco suggested on 10 July that Italian banks could borrow

more than €200bn in TLTRO funds. Note that the 7% allowance for Italian banks in the two

initial TLTROs amount to c. €75bn. At the same time, Unicredit’s CEO indicated his bank could

draw on €14-15bn, half of which would be in Italy, while Monte dei Paschi’s CEO said that hisbank could draw up to €6bn of TLTRO.

Olivia Frieser, Greg Venizelos



RESEARCH DISCLAIMERSThis document has been written by our strategy teams. It does not purport to be an exhaustive analysis, and may be subject to conflicts ofinterest resulting from their interaction with sales and trading which could affect the objectivity of this report. This document is a marketingcommunication and is not independent investment research. It has not been prepared in accordance with legal requirements designed toprovide the independence of investment research, and is not subject to any prohibition on dealing ahead of the dissemination of investmentresearch.

STEER™ is a trade mark of BNP Paribas

The information and opinions contained in this report have been obtained from, or are based on, public sources believed to be reliable, but no representation or

warranty, express or implied, is made that such information is accurate, complete or up to date and it should not be relied upon as such. This report does not constitutean offer or solicitation to buy or sell any securities or other investment. Information and opinions contained in the report are published for the assistance of recipients, butare not to be relied upon as authoritative or taken in substitution for the exercise of judgement by any recipient, are subject to change without notice and not intended toprovide the sole basis of any evaluation of the instruments discussed herein. Any reference to past performance should not be taken as an indication of futureperformance. To the fullest extent permitted by law, no BNP Paribas group company accepts any liability whatsoever (including in negligence) for any direct orconsequential loss arising from any use of or reliance on material contained in this report. All estimates and opinions included in this report are made as of the date ofthis report. Unless otherwise indicated in this report there is no intention to update this report. BNP Paribas SA and its affiliates (collectively “BNP Paribas”) may make amarket in, or may, as principal or agent, buy or sell securities of any issuer or person mentioned in this report or derivatives thereon. Prices, yields and other similarinformation included in this report are included for information purposes. Numerous factors will affect market pricing and there is no certainty that transactions could beexecuted at these prices.BNP Paribas may have a financial interest in any issuer or person mentioned in this report, including a long or short position in their securities and/or options, futures orother derivative instruments based thereon, or vice versa. BNP Paribas, including its officers and employees may serve or have served as an officer, director or in anadvisory capacity for any person mentioned in this report. BNP Paribas may, from time to time, solicit, perform or have performed investment banking, underwriting orother services (including acting as adviser, manager, underwriter or lender) within the last 12 months for any person referred to in this report. BNP Paribas may be aparty to an agreement with any person relating to the production of this report. BNP Paribas, may to the extent permitted by law, have acted upon or used theinformation contained herein, or the research or analysis on which it was based, before its publication. BNP Paribas may receive or intend to seek compensation for

investment banking services in the next three months from or in relation to any person mentioned in this report. Any person mentioned in this report may have beenprovided with sections of this report prior to its publication in order to verify its factual accuracy.This report was produced by a BNP Paribas group company. This report is for the use of intended recipients and may not be reproduced (in whole or in part) ordelivered or transmitted to any other person without the prior written consent of BNP Paribas. By accepting this document you agree to be bound by the foregoinglimitations.Certain countries within the European Economic Area:This report is solely prepared for professional clients. It is not intended for retail clients and should not be passed on to any such persons. This report has been approvedfor publication in the United Kingdom by BNP Paribas London Branch. BNP Paribas London Branch (registered office: 10 Harewood Avenue, London NW1 6AA; tel: [4420] 7595 2000; fax: [44 20] 7595 2555) is authorised by the Autorité de Contrôle Prudentiel et de Résolution and the Prudential Regulation Authority and subject tolimited regulation by the Financial Conduct Authority and Prudential Regulation Authority. Details about the extent of our authorisation and regulation by the PrudentialRegulation Authority, and regulation by the Financial Conduct Authority are available from us on request. BNP Paribas London Branch is registered in England andWales under no. FC13447. www.bnpparibas.com

This report has been approved for publication in France by BNP Paribas SA, incorporated in France with Limited Liability and is authorised by the Autorité de ContrôlePrudentiel et de Résolution (ACPR) and regulated by the Autorité des Marchés Financiers (AMF) whose head office is 16, Boulevard des Italiens 75009 Paris, France.

This report is being distributed in Germany either by BNP Paribas London Branch or by BNP Paribas Niederlassung Frankfurt am Main, a branch of BNP Paribas S.A.whose head office is in Paris, France. BNP Paribas S.A. – Niederlassung Frankfurt am Main, Europa Allee 12, 60327 Frankfurt is authorised and supervised by the

Autorité de Contrôle Prudentiel et de Résolutionand it is authorised and subject to limited regulation by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin).United States: This report is being distributed to US persons by BNP Paribas Securities Corp., or by a subsidiary or affiliate of BNP Paribas that is not registered as aUS broker-dealer to US major institutional investors only. BNP Paribas Securities Corp., a subsidiary of BNP Paribas, is a broker-dealer registered with the U.S.Securities and Exchange Commission and a member of the Financial Industry Regulatory Authority and other principal exchanges. For the purposes of, and to theextent subject to, §§ 1.71 of the U.S. Commodity Exchange Act, this report is a general solicitation of derivatives business. BNP Paribas Securities Corp. acceptsresponsibility for the content of a report prepared by another non-U.S. affiliate only when distributed to U.S. persons by BNP Paribas Securities Corp.

Japan: This report is being distributed to Japanese based firms by BNP Paribas Securities (Japan) Limited or by a subsidiary or affiliate of BNP Paribas not registeredas a financial instruments firm in Japan, to certain financial institutions defined by article 17-3, item 1 of the Financial Instruments and Exchange Law EnforcementOrder. BNP Paribas Securities (Japan) Limited is a financial instruments firm registered according to the Financial Instruments and Exchange Law of Japan and amember of the Japan Securities Dealers Association and the Financial Futures Association of Japan. BNP Paribas Securities (Japan) Limited accepts responsibility forthe content of a report prepared by another non-Japan affiliate only when distributed to Japanese based firms by BNP Paribas Securities (Japan) Limited. Some of theforeign securities stated on this report are not disclosed according to the Financial Instruments and Exchange Law of Japan.

Hong Kong: This report is being distributed in Hong Kong by BNP Paribas Hong Kong Branch, a branch of BNP Paribas whose head office is in Paris, France. BNPParibas Hong Kong Branch is registered as a Licensed Bank under the Banking Ordinance and regulated by the Hong Kong Monetary Authority. BNP Paribas HongKong Branch is also a Registered Institution regulated by the Securities and Futures Commission for the conduct of Regulated Activity Types 1, 4 and 6 under the

Securities and Futures Ordinance.Israel: BNP Paribas does not hold a licence under the Investment Advice and Marketing Law of Israel, to offer investment advice of any type, including, but not limitedto, investment advice relating to any financial products”

Singapore: BNP Paribas Singapore Branch is regulated in Singapore by the Monetary Authority of Singapore under the Banking Act, the Securities and Futures Actand the Financial Advisers Act. This document may not be circulated or distributed, whether directly or indirectly, to any person in Singapore other than (i) to aninstitutional investor pursuant to Section 274 of the Securities and Futures Act, Chapter 289 of Singapore ("SFA"), (ii) to an accredited investor or other relevant person,or any person under Section 275(1A) of the SFA, pursuant to and in accordance with the conditions specified in Section 275 of the SFA or (iii) otherwise pursuant to,and in accordance with the conditions of, any other applicable provisions of the SFA.

Australia: This material, and any information in related marketing presentations (the Material), is being distributed in Australia by BNP Paribas ABN 23 000 000 117, abranch of BNP Paribas 662 042 449 R.C.S., a licensed bank whose head office is in Paris, France. BNP Paribas is licensed in Australia as a Foreign Approved Deposit-taking Institution by the Australian Prudential Regulation Authority (APRA) and delivers financial services to Wholesale clients under its Australian Financial ServicesLicence (AFSL) No. 238043 which is regulated by the Australian Securities & Investments Commission (ASIC).The Material is directed to Wholesale clients only and isnot intended for Retail clients (as both terms are defined by the Corporations Act 2001, sections 761G and 761GA). The Material is subject to change without notice andBNP Paribas is under no obligation to update the information or correct any inaccuracy that may appear at a later date.

Brazil: This document was prepared by Banco BNP Paribas Brasil S.A. or by its subsidiaries, affiliates and controlled companies, together referred to as "BNP Paribas",for information purposes only and do not represent an offer or request for investment or divestment of assets. Banco BNP Paribas Brasil S.A. is a financial institution

duly incorporated in Brazil and duly authorized by the Central Bank of Brazil and by the Brazilian Securities Commission to manage investment funds. Notwithstandingthe caution to obtain and manage the information herein presented BNP Paribas shall not be responsible for the accidental publication of incorrect information nor for

http://www.bnpparibas.com/

http://www.bnpparibas.com/

BNP ECB QE Revisited

Documents

Transcript of BNP ECB QE Revisited