by Darren Williams, Senior Economist, Europe, AllianceBernstein
The European Central Bank (ECB) is widely expected to announce a winding down of its quantitative easing (QE) program on October 26. Though investors are nervous, the ECB is doing a good job preparing markets for the change.
As the ECB gears up for its October meeting, the Governing Council has yet to agree on how to taper its QE program. Indeed, the ECB has been surprisingly quiet about its policy options.
That’s changed in recent days, though. Several members of the Governing Council—particularly Chief Economist Peter Praet—have provided important insights on the most likely options.
Praet made the following observations:
- The ECB’s asset purchases should be seen in the context of its other policy instruments. More specifically, the Governing Council’s forward guidance—which states that policy rates won’t rise until “well past the horizon of our net asset purchases”—contains important information about the likely timing of the first rate hike. The longer the program lasts, the later the first hike is likely to be.
- The impact of central bank asset purchases depends on the state of the economy and markets at the time. In other words, when market conditions are tense, a high purchase pace over a short period is more effective. In more normal conditions (like today), a lower purchase pace over a longer horizon can be more effective.
- The average maturity of the ECB’s bond holdings falls as its portfolio ages, putting upward pressure on bond yields. Replacing maturing securities with longer-dated bonds can help ease the pressure, but by itself isn’t sufficient to prevent a gradual—and, at this point, inappropriate—tightening of financial conditions.
At the October meeting, the market will primarily focus on the intended pace and length of the ECB’s asset purchases next year. Although a hybrid solution is possible, we believe that the choice is between a six-month extension at €40 billion per month and a nine-month extension at €20 billion per month. We increasingly think the ECB will opt for a nine-month extension at €20bn per month.
But the Governing Council has other big decisions to make. It will also have to decide if the time is right to set an end date for the program (possible, but unlikely). And, it may consider whether to drop its promise to ramp up purchases again if the outlook begins to deteriorate (highly unlikely, in our view).
What about the ageing of the ECB’s balance sheet? To address Praet’s third point, the ECB could also announce plans to actively manage its bond holdings—a European version of the Federal Reserve’s Operation Twist.
Managing Market Expectations
As usual, some compromise may be necessary. But if the ECB opts for a nine-month extension at €20bn per month, it may succeed in appeasing opposing camps. For the hawks, it would represent a big reduction in the monthly purchase pace, as well as a lower volume of additional purchases. For the doves, it would help prevent the market pricing in an early rate hike.
And there’s the rub. The Governing Council now seems in broad agreement that the time is right to taper its asset purchases. But it needs to do this without the market pricing in early rate hikes, which could undermine the recovery.
That’s why the messaging has started to change. Some Governing Council members, including ECB President Mario Draghi, are shifting the emphasis away from the end of the program toward the timing of the first rate hike. They want us to believe that the gap between the two is likely to be a long one.
Taper Tantrum Unlikely
So how are markets likely to respond if we’re correct? Stepping down from a monthly purchase pace of €60bn to €20bn will be a bitter pill for markets to swallow.
And, as ECB tapering will coincide with the Fed’s wind-down of its own balance sheet, it’s likely to put upward pressure on bond yields.
But we’d expect this pressure to be contained. So far, the ECB has done a very good job of managing the market’s tapering expectations, and we expect it to continue to do so.
The one exception has, perhaps, been the strength of the euro. But with more Fed rate hikes on the horizon and the ECB working hard to push back on the timing of its first rate hike, we think further euro upside is limited.
For European risk assets more generally, two key points stand out:
First, the ECB is tapering its bond purchases because the economy is strong and no longer needs them.
Second, low inflation means the ECB will withdraw monetary accommodation very gradually. So as long as the Governing Council gets its communication strategy right—and recent omens have been good—we think there’s little to fear.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.
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