Beyond Bulls & Bears

Fixed Income

Do Markets Fully Understand the Implications of ECB Tapering?

For months, markets have been anticipating that the European Central Bank (ECB) would announce a timeframe for tapering its quantitative easing programme. As the ECB confirms its plan for 2018, David Zahn, Franklin Templeton Fixed Income Group’s head of European Fixed Income, asks whether markets fully understand the implications of the move. And, he explains why he expects the ECB to remain cautious and accommodative for some time to come.

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At its latest policy meeting, the European Central Bank (ECB) has confirmed it will begin tapering its quantitative easing programme from January next year, cutting monthly purchases to €30 billion from €60 billion. But we’re not convinced that markets have yet understood the full implications of that decision.

The decision should set the ECB on the path to monetary policy normalisation, but we don’t expect it to be a quick journey. We expect the eurozone to maintain an accommodative approach and low interest rates for some time to come.

In that regard, the eurozone is taking a different approach from the United States, which has a similar growth and inflation profile. And, like the eurozone, the United States is witnessing extremely low levels of unemployment.

Yet the respective central banks are moving in opposite directions. The US Federal Reserve is not only hiking interest rates and reducing the size of its balance sheet by not reinvesting the maturing assets, it is also talking about outright asset sales.

That situation seems some way off for Europe, in our eyes. We expect eurozone quantitative easing (QE) to continue until at least 2019.

Justified Caution

Despite confidence in the strength of the European economy, we think the ECB is right to be cautious in its approach.

The central bank has already spent more than €2 trillion on asset purchases since embarking on its QE programme in March 2015. In our view, it will want to make sure it doesn’t do anything to upset the market in a way that could make that commitment redundant.

Crucially, eurozone inflation is still some way off the ECB’s 2% target, so we reckon monetary policy needs to remain accommodative. At the same time, although Draghi and his colleagues have been careful to telegraph their plans, they will be conscious that sometimes markets can be spooked as reality dawns.

One issue that some investors may not have fully appreciated is that government bonds are likely to bear the brunt of the majority of the asset-purchase reduction. We expect non-governmental purchases, including covered bonds, to remain largely stable at around €10 billion a month.

So, we’re potentially looking at a reduction in government bond purchases from €50 billion a month to €20 billion a month. That kind of change could have a significant impact on certain markets— notably the European periphery, for which the ECB has been a major purchaser.  And, it’ll be really important to see how the markets react.

We could potentially see an upward bias in some of those markets as investors digest exactly what the disappearance of a major purchaser (one which isn’t price sensitive) could mean.

Even as the ECB winds down its asset purchases, we would expect to see the bank reinvesting in maturing securities.

That reinvestment is likely to serve almost as a substitute for QE and could maintain the downward pressure on yields for longer. Furthermore, it reinforces our view that an outright ECB interest-rate hike is unlikely before 2020 at the earliest.

External Influences

As well as economic considerations, the ECB policy makers will have one eye on political developments in Europe which might also support the “lower for longer” and accommodative stance we expect the ECB to take.

There are no obvious red flags we see on the horizon that could derail the recovery, but there are a number of smaller irritants that could have the potential to distract the overall economy temporarily.

We don’t think the disagreements between the governments of Spain and Catalonia are yet at the stage of having a major impact on financial markets. However, some investors might not want to invest in Catalonia or even Spain as a whole because of this constitutional uncertainty.

We feel an escalation of the conflict in Spain could put a dampener on Spanish growth.

Potentially of more concern are the Brexit negotiations, which continue to rumble along seemingly without much progress.

A crash Brexit, in which the United Kingdom exits the European Union without any trade deal, would likely impact the eurozone economy negatively. It could cause some disruption just as the ECB is trying to conduct its own exit from its QE programme.

Any impact would likely be felt especially in those countries that have been the growth drivers of the eurozone, such as Germany, the Netherlands and Ireland.

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What Are the Risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments.