The long-feared moment of bond tapering in the eurozone has arrived. The comfort blanket is being pulled away – gently – for the first time since the region first crashed into a debt crisis.
The European Central Bank has tried to cushion the blow with dovish rhetoric and a glacially slow exit but there is no denying that monetary policy has reached a critical turning point. „The ECB has delivered an unwelcome surprise,“ said Luigi Speranza from BNP Paribas.
Europe’s incipient tightening has begun just as the US Federal Reserve prepares to raise interest rate next week, probably the first of several rises over the next twelve months as the incoming Trump administration launches a fiscal boom.
It comes as China takes action to choke off a property bubble and rein in shadow banking. The world’s three big monetary blocs will all be draining liquidity at the same time.
The ECB will wind down quantitative easing from €80bn to €60bn a month when the current programme expires in March. Societe Generale says that this is just the start, predicting more tapering of €10bn in June, and then further cuts of €10bn at each meeting – a truly drastic outlook.
Doves at the ECB warned that it would be dangerous to start any tapering at this delicate juncture, given that there has been no flicker of life in core inflation – still stuck at 0.8pc – and given that imported monetary tightening from the US has already led to a doubling of Italian 10-year yields over the last three months.
The doves were over-ruled. It is clear that a German-led bloc on the ECB’s governing council blocked efforts to roll over the existing QE structure for another six months.
Bond purchases will carry on for longer instead. The new €60bn regime will run for nine months until the end of 2017. The ultimate stock of ECB bonds will be higher. You could call it a compromise. But despite appearances – and logical inference – these are not an equivalent forms of stimulus.
The stormy saga of bond tapering by the Fed shows that investors react more to the monthly „flow“ of QE than they do to the „stock“ of bonds held – the balance sheet syndrome that looms large in the theoretical models of central banks.
The Fed was caught badly off guard by the violent reaction of the markets when it began trying to exit QE – claiming absurdly that it was not tightening – and was forced to retreat at first.
The Atlanta Fed’s ‚Wu-Xia‘ analysis suggests that the ultimate effects of US tapering were equivalent to twelve rate rises. It proved to be serious tightening after all, and did in fact bring the US economy to brink of recession in early 2016.
If the Wu-Xia model applies to Europe – and this is contested – the ECB is implicitly delivering a monetary policy shock even by cutting from €80bm to €60bn, and it is doing so before the eurozone economy has broken out of its deflationary low growth trap.
Mario Draghi, the ECB’s president, was at pains to insist that there is no tightening whatsoever coming next year. „The presence of the ECB on the markets will be there for a long time. The key message is that there is no tapering in sight,“ he said.
Nothing is on auto-pilot and the volume of QE could rise again if need be. „It can go back to €80bn,“ he said.
Few are convinced. „This is effectively tapering in our view. It continues a trend among major central banks of moving away from ever-looser monetary policy,“ said Marilyn Watson from Blackrock.
Marc Ostwald from ADM accused Mr Draghi of trying to pull the wool over everybody’s eyes with „rhetorical camouflage“.
„However much Draghi tried, he could not refute the point that cutting to €60bn month could be a staging post to further cuts, because it is simply not refutable,“ he said.
Mr Draghi’s manouvres are not without cunning. The decision to buy bonds with yields below the ECB’s deposit floor of minus 0.4pc opens up the field of buyable debt. This means that the Bundesbank can keep buying German bonds for longer, and heads off the toxic issue of back-door ‚mutualisation‘ where the Bundesbank starts having to buy other countries’s debt in order to keep QE going.
But there is a sting in the tail. The Bundesbank will lose money instantly each time it buys one of these bonds. This is going to cause political trouble in Germany just as the electoral season moves into full swing.
For now markets are taking Mr Draghi’s assurances at face value. European equities rallied. Germany’s DAX indes rose 1.75pc on the day.
Italy’s MIB continued to its extraordinary rebound since the landslide defeat of premier Matteo Renzi last Sunday, with battered bank stocks hitting a six-month high. Unicredit has jumped 30pc in three days.
Yet there is edginess in southern Europe’s debt markets. Yields on 10-year bonds have ticked up nine basis points in Spain, 12 in Italy, and 24 in Portugal, where borrowing costs are approaching a three-year high.
At best Mr Draghi is taking a gamble. Italian banks hold €400bn of Italian sovereign bonds and the more they lose on this portfolio as yields rise, the more they erode their core capital ratios, and deeper the hole they have to get out of.
The ECB is tightening the spigot even though it has revised down its estimates of core inflation for next year and warned that economic risks are „tilted to the downside“. US tapering took several months to hit. Much the same is on the cards in Europe.
„The markets are likely to become more sensitive from now on to data and news flow. The ECB ‚insurance‘ is now less compelling, leaving peripheral bonds more exposed to political developments,“ said BNP Paribas.
Or in blunter terms, the weaker states of southern Europe are on their own now.