Will Renzi's referendum complicate Draghi's decision?

Italian referendum to set the mood

The mood in financial markets on Monday will almost certainly be set by the outcome of Sunday’s Italian referendum. Results of exit polls, which might not prove reliable, are likely to be available from about 11pm CET on Sunday night, while the final results are expected any time from around 3am CET on Monday morning. Regardless of the narrow constitutional pros and cons of the measures being voted upon – which would strengthen the hand of any Italian government by shrinking parliament’s upper house and stripping it of most of its legislative powers and power of veto – investors are most concerned about the immediate political ramifications as Prime Minister Renzi has staked his future on the outcome. Should Renzi see the referendum endorse his proposals, investors would seem likely to breathe a sigh of relief and give new support to Italian asset prices, which until the start of this week had significantly underperformed. But given the opinion polls published before the blackout period commenced two weeks ago, it seems more likely that Renzi’s proposals will be rejected and Italian asset prices will take a further hit. Indeed, while reports suggest that the ECB would be prepared to increase its purchases of Italian bonds to try to ease some of the immediate pain, we suspect that it would be a while before support from Frankfurt became apparent and that the central bank would not consider a rise in Italian spreads to be inappropriate.

Several possible political paths ahead after the vote

In the event that Renzi’s proposals are rejected, political uncertainty would certainly be once again to the fore and economic policy drift – as seen in Spain when left without effective government over the past year – would seem inevitable. Given the major challenges faced to sustain Italy’s economic recovery and deal with the huge stock of non-performing loans in the banking sector, that is definitely cause for concern. But the ultimate political consequences of a ‘no’ vote would not necessarily be dire. While the populist Five Star Movement, which has advocated a consultative referendum on Italian membership of the euro, might possibly win the largest share of the vote in any snap general election, opinion polls suggest that is less likely. Moreover, the rejection of Renzi’s reforms to the upper house would diminish the scope of any such future populist government to take such drastic action in future. If voter turnout is very low, it is even possible that Renzi would be asked by President Matterella to stay on as Prime Minister. More likely, however, would be the installation of a new technocrat government, perhaps led by current Finance Minister Padoan, to oversee a transition to new elections in 2017 or early 2018. And in that case, there might well be sufficient support, from Renzi’s centre-left Democratic Party, Berlusconi’s centre-right Forza Italia and certain others, for new reforms to the process for electing the lower house, which might further diminish the possibility of a future majority Five Star Movement government, to be enacted before any new general election.

ECB set to announce QE extension

The other main event of the coming week will, of course, be Thursday’s ECB monetary policy announcement, which looks set to determine the future of the asset purchase programme beyond next March. Regardless of the outcome of Renzi's referendum, the policy decision will be dictated by the ECB’s updated forecasts. While recent economic surveys have suggested a slight pickup in recovery momentum in the current quarter, particularly in Germany, policymakers seem unlikely to revise significantly their previous forecasts for GDP growth of 1.6% in both 2017 and 2018. Most important, however, will be the forecast for inflation. Members of the Governing Council will expect headline CPI to rise back above 1%Y/Y as energy prices start to make a positive contribution and the recent depreciation of the euro provides a modest boost. However, with core inflation stuck stubbornly at just 0.8%Y/Y over each of the past four months and wage growth weaker than previously anticipated, they will expect CPI to remain below the ECB’s target of close to 2%Y/Y over the forecast horizon, perhaps predicting it to reach about 1.6% in 2019. At the Governing Council’s previous meeting in October, Draghi committed to ‘preserve the very substantial degree of monetary accommodation that is necessary… [to meet the inflation target] without undue delay’. And given previous ECB assessments of the impact of its policies on inflation, we expect the coming week’s meeting to announce an extension of the QE programme beyond next March with the extra asset purchases amounting to roughly €500bn.

What rate of purchase?

In his interview published in the Spanish newspaper El Pais on 30 November, Draghi acknowledged that the ECB ‘can deliver the appropriate [policy] stance by different combinations of instruments, for instance the amount of monthly purchases or the length of time over which they take place’. And so, the precise timeframe for the purchase extension, and hence the implied monthly rate, is uncertain. However, not least since a decision to buy the additional assets at a slower rate would be interpreted by financial markets as tapering and trigger a tightening of financial conditions – against the backdrop of already significant recent increases in bond yields well above levels previously expected by the ECB – we expect the rate of asset purchases to be maintained at the current rate of €80bn per month until at least September 2017.

Which rules to be relaxed?

While rising bond yields have recently increased the pool of bonds available for the ECB to buy under current rules, to achieve the extra purchases the ECB will still need to relax some of those self-imposed constraints. With 2Y German yields still firmly below -70bps, the bond market is positioned for the -40bp floor yield on purchases to be removed. However, the Governing Council might simply prefer to raise the issue limit for bonds without collective action clauses above the current limit of 33% (but still below 50%), a measure which seems less controversial. And the introduction of greater flexibility with respect to the share of purchases of each member state, which is currently relatively strictly determined by the ECB’s capital key, would seem practical and harmless. Reports have also suggested that the Governing Council will announce changes to its securities lending facility to support market liquidity. Whichever measure or combination of measures is agreed by the Governing Council, expect bond markets to adjust accordingly.

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