The European Central Bank (ECB) has pledged to extend its €2.3 trillion bond-buying programme until December 2017 and to keep key interest rates unchanged until thereafter. But then, in 2018, the ECB is likely to begin its slow descent from easy monetary policy.
The global economic upturn puts new pressure on central banks to retreat from the easy monetary policies that have propped up their economies since the 2008 crisis. Normalising policy early could prevent inflation overshooting in countries where it is already ticking upwards, like in Germany or the Netherlands, but may stifle the recovery in peripheral countries. To avoid getting ahead of the curve, the ECB uses four criterion designed to signal a sustainable, broad-based rise in inflation. Only two of these have been met so far.
Mario Draghi, the ECB President, has emphasised that the ECB will taper its €60bn-per-month bond-buying program before normalizing the negative deposit rate. If growth persists and if there are no unforeseen shocks, we expect the ECB will begin reducing their bond-buying in January 2018 by around €10bn per month up until June the same year. Whilst markets digest the new liquidity, it’s likely the ECB will slip into neutral gear until October 2018 or so. Then, we believe, they could begin raising the depositary facility rate, but very gradually to avoid any undesired market reactions. We project it will not reach zero until June 2019.
When the invisible hand of the ECB is withdrawn, the weakest EU economies will be hurt the most as the cost to service their debt will rise. By buying bonds, the ECB keeps prices artificially high, and the yield (which Governments must pay to bondholders) low. At over 130% of GDP, Italy’s Government debt mountain is Europe’s Achilles’ heel. The 5-year government bond spreads of Italy and Spain against the German Bund, could widen to around 85 and 40 basis points (bps) respectively this year, amidst tapering talk. With five-year spreads, some of the widening will be mitigated by the ECB’s latest targeted longer-term refinancing operation (TLTRO). However, the spread on 10-year Government bonds of Italy and Spain, against the Bund, could reach 250 and 170 bps, respectively, by the end of 2017 according to Pictet Wealth Management.
In mountaineering they often say the descent is more difficult than the climb. The ECB can surely relate as they start to map out the return leg of their venture in easy monetary policy. As the artificial reality in European markets of low prices and cheap money comes to an end, bond investors especially may want to re-assess their positioning in anticipation of rising yields. On the same note, rising yields and monetary tightening will be a hologram of sustainable growth which could benefit equity markets. We now look to the next ECB meeting on June 8th, where we expect Draghi to maintain his cautious stance towards tapering for now, despite mounting pressure to tighten policies from core nations.