ECB: Managing the “Great Unwind”

Published on July 19, 2017

With a Eurozone economy that is practically firing on all cylinders, but with inflation still lagging behind, European Central Bank President Mario Draghi has the luxury of time, and will attempt to make no waves in markets when he emerges from the ECB Governing Council meetings tomorrow.

If anything, Draghi will attempt to dampen down speculation over the ECB exit strategy plans, doing his best to steer expectations through the summer, to the next ECB policy meeting on September 7. In that, we wish him luck.

*** Starting with tomorrow’s presser and right up through his high-profile speech at the Federal Reserve Bank of Kansas City’s annual retreat at Jackson Hole in late August, President Draghi is likely to message a deliberate, measured plan and process to the ECB’s much-awaited Exit from its bond purchase program. To dampen speculation over a quickened pace of the taper or an early rate hike, we expect a particular focus from the ECB president on a gradual sequencing of a full taper before any lift-off from the current negative deposit rate. ***

*** There is a firm Governing Council consensus on the sequencing in the gradual removal of monetary accommodation, tapering the bond purchases in full before lifting rates from the current -0.4% policy rate. While it will ultimately depend on the assessment of market conditions and the economic outlook, and various alternatives will be considered, we believe the base case on the pace of the taper is still likely to be a gradual reduction by perhaps 10 billion euros a month, or per meeting, through the first half of next year, that would put the first rate hike in the third quarter of 2018 at the earliest. ***

*** The taper’s composition is unlikely to be rigidly proportional or formulaic, and we understand the ECB may focus first on tapering the sovereign bond purchases while dragging out the corporate paper purchases a bit longer.  The ECB will, however, be careful to mechanically follow the same objective “ECB Key” in its taper of the sovereign bond purchases, and is very likely to avoid favoring core over peripheral sovereign bonds in the composition of the taper. ***

The Shadow of Sintra

By the September ECB meeting, with the 60 billion Euro per month bond purchase program slated to run until the end of 2017, the broader principles of the exit plan will in all likelihood have been internally discussed at greater length, formulated, and readied to be rolled out.

The whole process could, in theory, drag out to the October 26 Governing Council meeting, with the final details perhaps not nailed down until the ECB year-end meeting in December. But ideally Berlin, which has been highly supportive of Draghi and the ECB, will be anxious to have some elements of policy normalization communicated or underway before the September 24 Federal elections in Germany (not that politics affects central bank policy ever).

With that measured and deliberate pace in mind, the Eurozone nevertheless has and continues to experience a strong, broad based recovery, even as inflation disappoints here and there, and the exit is now plainly in sight.

To put perspective on the breadth as well as strength of that growth, ECB officials, for example, note that out of a universe of 162 sectors the ECB tracks across the Eurozone, over 80% are still growing, and the dispersion between them is the lowest on record since 1997.

And so even while cautious, Draghi and ECB officials will repeat a message that will temper expectations, but still warn and clearly point to a continued drift upwards in market rates.

That is to stress that as the Eurozone economy continues to recover, and with it inflation, while dipping recently, hopefully stabilizes and recovers again as forecast, current nominal rates, by definition, will become more accommodative when measured in effective, real terms.

And so a slow upward creep up in yields across the Eurozone would be a natural response that would simply represent an effective maintenance of the very accommodative current interest rates in real terms, even if that means a shift upwards in nominal rates.

Rates, in other words, are going higher, however gradually.

That, ECB officials say, is the key message markets need to take from President Draghi’s now famous speech on June 27 in Sintra, Portugal, a message that is likely to be repeated and reinforced across the Governing Council as the recovery sets in, and as the exit gets closer.

Sequencing, QE, and the Taper

That by no means suggests a hike in the negative deposit rate is on the table or anywhere on the near-term horizon.

After a messaging mishap and violent market reaction earlier this year, the ECB Governing Council is in full agreement on the “sequencing” of the exit strategy: namely that interest rate hikes are only to come once the asset purchase program has been wound down, and that also excludes any concurrent rate hikes with a taper.

That would put a hike from the current -0.4% deposit rate in the third quarter of 2018 at the very earliest – under a scenario for example where the ECB would taper its program at a pace of 10 billion Euros per month (or meeting) from the current 60 billion Euro level over the course of the first six or nine months of 2018.

The ultimate adoption and course of that taper program however is, as suspected in markets, still very much up in the air, and will depend on the ECB readings and confidence in market conditions as well as on the data over the next few months, most importantly the inflation readings.

There is for example a possibility, recently floated, that the taper could start with a more cautious “step down” in purchases first, for example from 60 to 40 billion Euros per month, for a few months come January, before a path is set towards zero.

While that is a completely plausible option, at this point in time we suspect the predisposition in the Governing Council will be to keep the taper on a simple and predictable straight-line path once the decision is made.

For one, while ECB officials will be hesitant to point to technical considerations guiding policy decisions, the issue of the scarcity of bonds available to purchase does and will factor in the background.

Furthermore, on a political level, while the German Bundesbank and other northern, more hawkish national central banks have been careful to maintain message discipline with Draghi and the ECB Executive Board, there is a strong undercurrent to finally “get on with it” and start the normalization process on asset purchases soon.

Too many undue delays at this point would fray that valuable consensus on the Council, and exacerbate fears over the negative consequences of continued large scale asset purchases and balance sheet expansion creating distortionary effects and potential problems in the markets, and with fiscal authorities, down the road.

All Bonds are Not Equal

Beyond timing and pace, ECB officials suggest the composition of the taper need not be rigidly proportional and formulaic, but could be executed in a more pragmatic fashion when the time comes. In other words, the taper might not – indeed we believe is likely not to – represent a straight reversal of the current purchases across asset classes.

From what we understand, the ECB will rather focus the taper more heavily first on its sovereign bond purchases, and drag out its purchases of corporate paper a bit longer, as those are seen to have a positive direct stimulative pass through effect on the real economy, without some of the complications of the sovereign QE.

When it comes to the composition of sovereign bond purchases, the ECB will, however, be careful to mechanically follow the same, objective, “ECB Key” metric it practiced on the way in.

Indeed, the ECB will be quick to squash any speculation it may taper more or less of, for example, core versus peripheral bonds – be it for technical reasons or to say protect the weaker economies of the south versus the growth engines of the north.

As a side note, investors may expect a straight-line proportional taper to put upside pressure on the spreads of the traditionally weaker peripheral bond markets to the core. But we suspect, barring an unforeseen accident or policy mistake, any such blowout may be limited, if it were to occur at all.

Indeed, the years of QE and extreme compression have built if anything an inordinate position and carry trade in safe-haven, core bonds. And it is these core bonds that to date seem to demonstrate the most extreme sensitivity, and vulnerability, to rumors and whiffs of the “Great Repricing,” or Unwind.

Back to list