In the latest Ahead of the Curve, Silvia Dall’Angelo, Senior Economist at Hermes Investment Management, analyses the impact of ECB tapering on European markets.
At its October meeting, the ECB announced a reduction of the monthly pace of its QE purchasing starting from January next year, officially embarking on the so-called tapering process. The monthly clip of purchases will be halved to €30bn over the first nine months of 2018. This move could mark the closing stage of the ECB QE programme, the so-called APP (Asset Purchase Programme), launched in early 2015.
It is going to be a gradual, predictable and flexible process
Significant improvements in economic conditions in the euro-zone over the last year or so have given the ECB the opportunity to start to dial down its APP. However, the ECB will adopt a cautious approach to tapering, and the process will be gradual, predictable and flexible. There are a few reasons for this. First and foremost, inflation is still undershooting the ECB’s target. In general, the recovery following the double hit from the Great Recession and the Sovereign Debt Crisis has been excruciatingly slow by historical standards and still looks vulnerable.
Even with tapering the overall monetary policy setting will remain highly accommodative over the next year at least. First, the forward guidance stating that the key ECB rates would remain at their present levels “well past the horizon” of QE was confirmed, suggesting the first rate hike will take place around mid-2019 at the earliest.
Importantly, tapering still implies that the ECB balance sheet will continue to grow, only at a slower pace. The announced tapering implies a QE addition of €270bn over 2018, pushing the ECB balance sheet up to €4.8bn (around 42% GDP) by September 2018. For the sake of comparison, if the ECB were to continue buying at the current monthly pace of €60bn over the next year, its balance sheet would increase to €5.2trn, or 46% GDP by the end of 2018 (Chart 1).
Beyond September 2018, the reinvestment policy of maturing bonds (which was confirmed for an “extended period” at the October meeting) will make sure that the ECB balance sheet will remain sizeable for a long time, while the flexibility embedded in the APP means purchases can be stepped up should adverse circumstances materialise.
Assessing the impact of ECB tapering: euro-zone yields to stay relatively low
A model for government bond yields based on a set of macro and market variables suggests that yields in core markets are typically less sensitive to QE than yields in the large peripheral markets. An additional 1% debt stock held by national central banks shaves around 3bps off German yields (on average across different maturities) compared to 4.5bps for Italian yields and 5.5bps for Spanish yields (Chart 2). Taking into account the stock of government debt (as a share of the total) national central banks have bought so far, the cumulative negative impact from QE purchases on yields so far is largest for Spain (150bps), followed by Germany (around 90bps) and Italy (around 80bps).
Unless the market interprets tapering as paving the way to a more aggressive balance sheet normalisation or rate increases in short order (unlikely), the ECB monetary policy stance will continue to provide downward pressures on bond yields (and to support asset prices), only with a lower intensity. Under tapering, yields will be 10-20bps higher by the end of 2018 compared to a hypothetical scenario where purchases were unchanged at a pace of €60bn per month.
The high sensitivities of peripheral yields to QE mean that peripheral rates might be more vulnerable to a phasing-out of the ECB purchasing programme. As the ECB tapers, markets are likely to shift their focus on fundamentals (growth differentials, sustainability of debt dynamics), potentially punishing structurally weaker countries.
In summary, the impact on European rates (and European financial assets in general) from ECB tapering is likely to be limited next year, which supports our ‘new normal’ view of low-for-longer global rates.
Chart 1. The ECB balance sheet will remain large in 2018
ECB balance sheet as % GDP (tapering vs. no tapering scenarios)
Source: Hermes Investment Management, based on ECB, Eurostat & CEPR data
Chart 2. Peripheral yields are more sensitive to QE than core
European yields’ sensitivity (pp) to a 1% debt stock held by NCBs, different maturities
Source: Hermes Investment Management, based on Bloomberg, ECB & Eurostat data