Market Outlook - BNP PARIBAS - Investment Services India

This section is classified as non-objective researchWe’ve mentioned the lack of confidence in eurozonestabilisation mechanisms. The recent discussion hasfocused mainly on the role of the EFSF and possibleways to leverage its intervention power. Why?Because the demand component of the EURgovernment bond pricing equation is becomingincreasingly significant now that we’ve had contagioninto Italy and the risk of further contagion into AAAhas increased.One way to analyse global demand trends is toreplicate the performance of customised portfolios vsglobal benchmarks. According to our investorintelligence, global EUR investors (especially centralbanks) have shifted from a EMU all-index tocustomised benchmarks (e.g. EMU3) in 2010, on theback of the severe underperformance in peripherycountries.In this context, Germany has been used as a proxyfor AAA EUR rates, France has been used as AAAwith some additional yield pick-up and Italy has beenused as a liquid, low volatility proxy for non-coreEMU. The performance of this custom benchmarksince July 2011 is impressively poor (Chart 5). At thesame time, volatility in Italy has picked upsignificantly, thus reducing its once excellent Sharperatio. Similarly, increased volatility is likely to limit theappetite even for AAA sovereign paper. Volatility hasrecently increased also in France and Germany.We’re looking for EUR 230bn of net supply fromeurozone governments in 2012, which is some 60bnless than our estimate of long-term trend demand.However, the benchmark argument exposed aboveis likely to further limit global demand and create theneed for external stabilisation (i.e. ECB).ECB to the rescue?We feel compelled to add to this discussion from thestandpoint of pure monetary policy. Using the ECBas a leveraging vehicle for EFSF operationsdemands several questions:1) Assume full EFSF lending capacity is needed,then the amount of outstanding OMO would jump toaround 880/890bn from current 480bn (assuming7.5% haircut on Liquidity 2 collateral with maturity>10Y).2) Even if the full amount is not needed at once, theEFSF's size is such that Eonia fixings would sufferfrom augmented volatility around open market ops.The money market is already a stressed market andadding further pricing uncertainty conflicts with theidea of smoothly functioning markets.3) Since EFSF funding is needed on a long-termbasis, we should expect significant excess liquidityconditions to prevail long-term. The ECB hasrepeatedly stressed that unconventional policymeasures are only "of temporary nature".4) A more or less permanent level of excess liquidityin the system has a permanent bias on theEonia/Refi spread (Eonia fixing closer to the depositfacility rather than to the policy rate, see Chart 6).Again, the ECB has repeatedly made clear that thismoney market distortion is not satisfying.5) Providing funds against EFSF collateral (directly)has limited impact on the transmission mechanismand the ability of the eurosystem to financeproductive businesses, as the EFSF would not belending to corporates directly.6) As described in 6.4.1. ("General risk controlprinciples"), the eurosystem may exclude specificcounterparties from monetary policy operations, "inparticular if the credit quality of the counterpartyappears to exhibit a high correlation with the creditquality of the collateral submitted by thecounterparty". The practice of cross-issuing eligiblecollateral has been criticised by the ECB. Thepractice of issuing 92% of currently outstanding OMOand shipping it into the ECB is highly questionable,especially if the collateral is 100% correlated with thecounterparty's credit risk.From a pure monetary policy perspective, buyinggovernment (and corporate) bonds directly is a betteroption for the ECB than adding a new layer betweendebtors and creditors. It would improve banks'balance sheet and sovereigns' primary financingability, while at the same time increasing the chanceof transmission to the productive private sector.Furthermore, increasing the SMP's size would alsoimprove market's confidence in the product (in thiscase the EUR government bond). But again, thereare several issues around a full scale QEprogramme, e.g. sterilisation, price stability, balancesheet guarantee, and so on. We’re not saying thatleveraging the EFSF via ECB cannot be done intheory; rather it is just not an optimal choice in thecontext of ECB's loss function.Alessandro Tentori / Ioannis Sokos / Camille de Courcel 20 October 2011Market Mover29www.GlobalMarkets.bnpparibas.com