Beyond Bulls & Bears

Fixed Income

On Central Bank Tapering and European Fixed Income

As markets try to look past the COVID-19 pandemic, the question of when central bank support will be withdrawn is a critical one. David Zahn, our Head of European Fixed Income, discusses the implications of potential tapering of asset purchase programmes, and what it means for fixed income investors.

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European markets broadly have been trading in a range in recent weeks, but the big discussion as we look beyond the summer holiday period is when central banks area going to start tapering their asset purchase programmes, which have provided economic support amid the COVID-19 pandemic.

On 27 August, all eyes were on the US Federal Reserve (Fed), which gathered for its annual policy symposium in Jackson Hole, Wyoming, with the theme of “Macroeconomic Policy in an Uneven Economy”. Fed Chairman Jerome Powell didn’t provide a specific timeframe, but hinted at starting to taper asset purchases, which is quite important because what happens in the US bond market will likely impact the European bond market.

The US central bank has been buying US$120 billion worth of Treasury and mortgage-backed securities monthly to support the economy—but at some point, this support will be withdrawn, particularly with signs of inflation heating up in the United States. While there’s an ongoing debate about whether this spike in inflation is temporary or longer lasting, many market observers see initial Fed tapering occurring before year end.

Inflation is also picking up in Europe above the European Central Bank’s (ECB’s) 2% target, which will probably put pressure on the ECB to start tapering its Pandemic Emergency Purchase Programme (PEPP). The PEPP was initially announced at €750 billion in March 2020, but the total has increased since then to €1.85 trillion. It is set to last until March 2022, so the ECB will either have to extend it—which looks unlikely—but could be partially offset by increased purchases in the Asset Purchase Programme (APP).  Therefore, we know purchases should be reducing, but it is more about at what speed and what is a new equilibrium level.

Even though both the Fed and ECB will likely move at slowly in terms of tapering, the reduction in purchases is significant, with two large price-insensitive bond buyers removed from the market. As such, we think this will likely push bond yields higher in both the United States and Europe. In Europe, we think the peripheral bonds will probably come under more pressure as the ECB has been a big buyer there—Italy in particular has been a big beneficiary.

Core European bonds are probably better anchored. That said, we don’t think yields will move dramatically higher; we think we’ll see a mild move up and then probably see bonds stabilise at new, still very low levels. In our view, bonds in Europe are not in for dramatic selloff, but we could see some volatility over the next couple of months as people digest the tapering on both sides of the Atlantic.

What Are the Risks?

All investments involve risks, 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. Investments in lower-rated bonds include higher risk of default and loss of principal. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.

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