Markets are expecting the European Central Bank (ECB) will signal in October a step-down from its current €60 billion per month in purchases. A recovery in eurozone growth—and a rise in inflation that is tentative, but has for now at least quashed deflation fears—has been part of the story fueling market expectations for a near-term ECB policy adjustment.
The main driver, however, is a perception that the central bank is running up against self-imposed limits in its asset-purchase program, as my colleagues and I write in our new Fixed income strategy The limits of “no limits”.
The ECB’s ownership share of German bunds threatens to breach a self-imposed limit in the first half of 2018. This suggests the central bank may need to tweak its quantitative easing program soon, while keeping policy accommodative overall.
The central bank’s balance sheet has ballooned since the launch of its public sector purchase program (PSPP) in 2015. The rapid growth in its holding of securities for monetary policy purposes—including holdings of government bonds and corporate credit—has helped double its size since 2015, as the chart below shows.
The market is increasingly focused on the natural limits to large-scale quantitative easing—despite ECB President Mario Draghi in 2015 professing no limits to “how far we are willing to deploy our instruments.” But the instruments have their limits: Eurozone central bankers are simply running out of bonds to buy.
The ECB added corporate bond purchases in 2016—before trimming its monthly asset purchases to 60 billion euros in April until the end of 2017, from 80 billion euros previously. The pace could be cut further as the central bank runs into limits. An improving growth backdrop should eventually lead to a sustainable move higher in eurozone inflation, justifying a removal of monetary accommodation. But we see inflation moving sideways in the near term—well below the ECB’s target. Our recently launched Inflation GPS, which incorporates big data on price trends and daily updates of traditional inflation-related statistics, is much lower than the ECB’s target given significant remaining slack in the eurozone economy. This is why we expect any reduction in ECB asset purchases to be modest and gradual.
The ECB’s next policy meeting in October will come just as the Federal Reserve (Fed) begins a well-telegraphed plan to start an outright slimming down of its balance sheet. Less bond buying by the ECB and outright balance sheet reduction plus further rate rises ahead from the Fed herald the end of crisis-era monetary policies that kept financial conditions loose and buoyed risk assets. The reversal has implications for global bond markets and financial markets more broadly. Rising rates could, over time, help restore the attractiveness of lower-risk government and shorter-duration debt—at the expense of more richly valued credit sectors that have benefited from the hunt for yield in recent years.
Low or negative rates have pushed investors out the risk spectrum, narrowing spreads on credit across global markets. And direct purchases of corporate bonds have provided a further support for European credit markets. Tightening financial conditions could also undermine future efforts at fiscal consolidation in the eurozone—and limit the scope of fiscal policy. The compression in sovereign bond yields has helped improve fiscal balances in recent years. But outside of countries participating in bailout programs (think Greece or Portugal), few have made progress on reducing their structural budget deficits—and now face a rise in debt-servicing costs as rates rise.
Against this backdrop, we are maintaining a defensive stance on European debt, given risks that appear skewed toward higher rates. We see euro corporate spreads as fairly priced versus global alternatives, but low yields leave little margin of safety. Read more market insights in our Fixed income strategy.
Listen to Richard Turnill and Jeff Rosenberg talk about BlackRock’s midyear investment outlook on the inaugural episode of our podcast, The Bid.