A likely QE extension (in October or December) implies that the ECB will be confined by its technical restrictions, making it difficult to proceed with purchases in all sovereigns - including Germany in early 2017.
Our main scenario is that the ECB will 'do nothing' (no change in restrictions) in September or in Q4, despite the increased focus on the German bond scarcity. No change in the restrictions would result in a 'de facto' deviation from the capital key in Ger/Fin/Por/Ire, causing 'tapering' in these countries while increasing purchases in other countries (according to the capital key). In this 'do nothing' scenario, Ita/Fra/Spa would tighten massively versus Germany, the German curve would steepen and Buxl/Bund ASWs would tighten.
Other possible ECB actions related to the QE restrictions would impact the EUR FI market differently. Buying below the deposit limit or lifting the issue/issuer limit would have significant implications for the EUR FI market curves and spreads. Switching from a 'capital key' to an 'outstanding debt key' would trigger a large repricing across sovereigns.
Market pricing. During the past month, the German curve has steepened with the 2Y yield decreasing to -68bp. Buxl ASW has tightened around 15bp since Brexit. The price action suggests that the market is pricing in some probability of abandoning the deposit restriction and an outcome that implies less buying of the long end of Germany. Price action in cross sovereign spreads has been more muted, indicating a low market probability of a 'de facto' deviation from the capital key.
There is no clear consensus on the most likely outcome nor the timing of the announcement. It is our impression that the majority expects the ECB to introduce some flexibility in the QE purchases, including possibly combining some of the above options.
Despite the significant impact on the FI market, a changed purchase pattern will not change the ECB's inflation outlook. It is just a step on the way and would buy the ECB more time before other assets (Senior Financials, equity ETFs) could be included in 2017.
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