Global policymakers, economists, and investors will turn their attention this week to Frankfurt, Germany, where the European Central Bank (ECB) Governing Council meets on Thursday, October 26.
The question is, of course, what will the Governing Council, which is the ECB’s decision-making body, say about monetary policy and the future of the ECB’s quantitative easing (QE) programme?
I, along with other members of our Global Debt team, recently attended the International Monetary Fund (IMF) and World Bank annual meetings. Those gatherings always provide a good opportunity to meet policymakers and other investors from around the world. While there, I had the chance to listen to ECB Chief Economist Peter Praet, as well as Central Bank of Italy Governor Ignazio Visco, both of whom are members of the ECB’s Governing Council.
Their comments were timely and informative ahead of this week’s important ECB Governing Council meeting. Praet was upbeat on economic growth, but highlighted that inflation dynamics remain subdued. He argued that monetary policy instruments would be recalibrated, which is the ECB’s euphemism for tapering, but would remain accommodative to ensure progress toward the ECB’s price stability objective. Visco expressed similar views. The remarks by both are in line with an ongoing ECB communication effort that aims to prepare the markets for the tapering of its bond purchases in 2018.
The ECB has done a fine job of communicating its intentions to the markets months ahead of the actual decision. The idea was to avoid a taper tantrum-type market reaction similar to what we experienced in 2013, when former U.S. Federal Reserve (Fed) Chairman Ben Bernanke signaled a possible end to the Fed’s QE. Markets were more nervous at the time and Bernanke’s announcement led to turbulence. Since then, central bankers around the world have been very cautious about communicating their expected actions and have flagged them carefully, well in advance. The ECB did the same, successfully in my view, but there are varying expectations about the details of the new policy package.
What We Expect at This Meeting
In our view, the ECB is on a path to slowly end its QE programme in 2018 but will remain an active buyer of bonds in the markets for most, if not all, of 2018. ECB President Mario Draghi indicated that the “bulk” of the ECB’s decisions regarding QE will likely be announced on October 26.
The ECB is currently purchasing bonds at a pace of EUR60 billion (US$71 billion) per month, until the end of 2017, but an extension to next year is widely expected. I believe the ECB Governing Council will announce plans this week to taper the bank’s monthly asset purchases to EUR30 billion for nine months, effective January 2018. I also expect the ECB to keep the QE end date unspecified at this stage, so that it retains the flexibility to calibrate the parameters of the program beyond the nine-month extension.
While there is widespread market expectation of tapering, or recalibration as the ECB prefers to call it, there is far less consensus on the parameters of the extension. For example, two recent polls suggest different combinations on the size of remaining purchases and duration.1,2
The ECB must have its own view of market expectations, and I believe its tapering package will be dovish. But the announcement could also include details about the programme’s implementation that will reinforce the dovish message. While markets focus primarily on asset purchases, the ECB always emphasises its overall package of policy measures, of which QE is only one part. Other measures include forward guidance about the future path of policy rates, the level of interest rates – including the negative deposit facility rate – and long-term financing operations. Some of these instruments can also be used to deliver a policy message.
A Likely Dovish Flight Path
So how could the ECB deliver a dovish message? The Governing Council will most likely emphasise the forward guidance and indicate that policy rates will not be raised in 2018. The ECB has already said rate hikes will take place “well-past the horizon” of QE, and it may use its communications effort to push market expectations of a rate hike beyond the early months of 2019. It can also suggest further flexibility in the types of assets that may be eligible for purchase, increasing the potential universe of assets it may buy for the remainder of the programme.
Another surprise could be about the ECB’s reinvestment policy. As time passes, the overall duration of the ECB balance sheet declines, and some of the bonds on the balance sheet will be maturing. Praet suggested that the ECB may also use its balance sheet policy to limit the decline of the duration of its portfolio.3 That would mean reinvesting maturing bonds at long maturities, an additional tool to avoid unwarranted tightening of financial conditions.
Reinvestment policy is unlikely to be used as an active tool to influence long-end rates, as in the case of Operation Twist in the United States.4 However, it can be used to smooth out volatility in long-end rates, and just signaling that could also be perceived as additional monetary stimulus.
Despite expecting a dovish surprise near-term, we believe the ECB is on a course to gradually end its QE next year. The markets are already expecting that this scenario will play out and that it will be followed by policy rate hikes in 2019. The direction for policy and sovereign bond rates should be higher from here onward. We believe in an environment in which rates gradually rise but the economy continues to grow and corporate profitability improves, European corporate bonds should continue outperforming sovereign bonds.
As for the euro, while the pause in its appreciation may persist for a while, we believe the euro’s longer-term direction should still be up. Valuation models suggest that the euro is still not expensive in historical terms. The expected end of extraordinary monetary stimulus and higher rates, improved growth prospects in the Eurozone, and a large current account surplus, all suggest the euro may continue to appreciate versus the dollar in the coming quarters.
- ^Source: “ECB to gently trim asset buys in delicate messaging act: Reuters poll,” 10/19/17.
- ^Source: “Economists Map Out Pacing and Timing of ECB’s QE Taper: Survey,” Bloomberg News, 10/22/17.
- ^Source: “Maintaining price stability with unconventional monetary policy measures,” Speech by Peter Praet, Member of the Executive Board of the ECB, SUERF Conference, New York, 10/11/17.
- ^Operation Twist is the name of a program conducted by the U.S. Federal Reserve (Fed) in late 2011 and 2012. The Fed bought long-term Treasuries and sold shorter-dated issues in an effort to bring down long-term interest rates and stimulate the U.S. economy.
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Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility as interest rates change.