‘Managing expectations’? Thoughts on ECB tapering potential

Core European bonds are weakening again today after a report suggesting that the European Central Bank could begin winding down its bond buying programme before its conclusion.

The notion has clearly come as a surprise, judging from the hefty market moves. Most ECB watchers had been focused on an extension of the length of the QE programme as the bank’s next move, and maybe even a rise in its pace.

fastFT has rounded up some reactions:

Rabobank’s rates team said “the strength of the market response” was likely partially driven by the fact:

that this topic perfectly resonates with the zeitgeist of speculation over central bank concern regarding the negative fallout from unconventional policymaking, as substantively backed up by the BoJ’s unveiling of “yield curve control” on Sep 21.

The Bloomberg report suggested issues of bond scarcity are one of the key drivers behind the shift to a taper consensus, but Rabobank’s rates team said:

The notion that supply issues may prompt a tapering of QE appears wholly misguided from an historical and mandate perspective.

Crucially, while not without financial, or indeed, political cost the ECB does enjoy considerable scope in terms of its ability to free up purchasable supply by adjusting the current QE parameters.

We would judge yesterday’s bearish price action to be a fleeting knee jerk reaction to the [Bloomberg] article and not the onset of a trend.

Piet Philip Christiansen at Nordea Bank is similarly dismissive of suggestions the ECB could be about to begin tapering:

We believe that ECB will extend the asset purchase programme beyond March next year by 6 months before tapering commences, as an abrupt halt would severely impact the market. We would expect a sharp sell-off, which Draghi surely will not want in case of an abrupt halt. Therefore, we believe that it is premature to expect tapering is just around the corner. Lessons from the US show that the previous Fed chair Bernanke first mentioned taper nearly 18 months before they eventually started.

However, Barclays research team suggests a form of tapering is both likely and necessary when the ECB does start to wind down the programme, whenever that is.

It notes that “inflation is far from self-sustaining without more QE”, but suggest that volumes of bond purchases substantially below the current €80bn a month will do the job:

To achieve the ECB’s baseline forecast of 2018 average growth and inflation both at 1.6%, purchases would need to average c. €45bn per month until end-2018. Importantly, and consistent with these estimates, the ECB could start with average monthly purchases of €70-60bn in 2017 and reduce purchases gradually towards c.€20bn per month

But the issue is how the ECB could reduce bond purchases without sparking a painful taper tantrum like the Federal Reserve in 2013.

Barclays notes:

Given the fragility of the euro area recovery, the ECB will want to transition to easing monetary policy at a slower pace without triggering a ‘taper tantrum’ like the Federal Reserve did accidentally in 2013. ECB forward guidance about the path of asset purchases could help to avoid this outcome.

But Barclays warns “simply re-iterating the ECB’s current forward guidance may not be enough to offset market participants’ surprise in response to a reduced pace of asset purchases.”

As such:

An ‘Odyssian’ approach, through tying asset purchases explicitly to economic conditions, might be more effective. For example, complementing the current guidance with explicit thresholds such as reaching 2% CPI inflation and an unemployment rate of 6% has a an important advantage: because these conditions are easily verifiable, there is very little room for the ECB to renege on promises made about asset purchases today in the future.

Frederik Ducrozet at Pictet echoes this sentiment:

QE tapering is not inconsistent with forward guidance, and it could be part of an exit strategy communicated to markets along with a clear contingency path, an option discussed in a recent ECB working paper.

However, Mr Ducrozet says:

Tapering is not an immediate issue for the ECB, which we believe is much more likely to announce an extension of QE and measures to deal with the scarcity of bonds it can purchase

We believe that QE tapering will not start before Q4 2017, and we still expect the ECB to announce that asset purchases will be extended by six months at the same €80bn monthly pace until September 2017, along with technical measures to deal with bond scarcity

And he warns:

The market reaction suggests that even if the Governing Council reached a consensus to taper now, it would find it all but impossible to do so without triggering a sharp, unwarranted tightening in monetary conditions.

As such, Mr Ducrozet says the leak could be “a trial balloon to prepare markets for QE tapering when it does happen.”

Or, he suggests:

Alternatively, the leaks could be aimed at managing expectations ahead of the 8 December meeting, drawing lessons from the disappointment that greeted policy measures unveiled in late 2015

The leaks could also be a superficial concession to the hawks ahead of a decision to extend QE.

Citi strategists note:

Our view on the matter is that it would probably be a serious policy mistake, given the several headwinds this region could be facing over the following quarters (many from the political front, but with serious repercussions on growth).

The current ECB assessment of the trajectory of headline inflation does not seem compatible with an immediate reduction in the monthly amount of asset purchases at the October/December meetings. Based on the initial market reaction to this newswire report, such a decision, if and when taken, would likely result in some tightening in financial conditions across the euro area. We doubt that this is what the Governing Council feels comfortable with at a time when inflation expectations are still struggling to rebound meaningfully.

They suggest this tapering story, regardless of its veracity, could quicken the recent sell-off that has driven up bond yields, particularly at longer maturities:

Whether true or untrue, we think the markets will be bothered further by comments like these. It could be much more than a pure change of speed. It might feel like a sudden stop.

It doesn’t matter how politely the Central Bank put it, the message is the same. All in all, we think this debate now, ahead of a natural (commodity driven) and gradual CPI move to a higher headline range in Europe may scare the back-ends further.

They suggest the repercussions could extend well beyond the European bond market, which has so far been the epicenter:

Even if markets judge these hawkish shifts to be policy mistakes, the initial reaction will likely be bearish for fixed income. A loss of confidence in the persistent availability of cheap liquidity will introduce an additional risk premium not only into yield curves but across asset classes funded by such cheap liquidity. Considering current market positioning, the initial reaction is thus likely to steepen core yield curves across the developed markets and hurt crowded and correlated positions across EM.

Persistent uncertainty could further hit risk appetite more meaningfully, which could damage sentiment towards EM too.

Louis Harreau at Crédit Agricole says the ECB will taper eventually, like the Fed, “as it seems to be the best way not to trigger a harsh reaction from the markets at the end of QE.”

“But it does not mean that it will taper tomorrow”, he says, and reiterates his forecast that:

The ECB will extend QE until September 2017 at €80bn a month, before tapering it by €10bn a month between October 2017 and April 2017.

He also ponders the source of the story:

It may be a good idea for the ECB to let markets under-price its next move: if investors fear that in December the ECB will announce a tapering Louis starting in March 2017, they will be relieved when the ECB announce s an extension of QE (and nothing more).

We think that the ECB may have some interest in assuring the market that it does not intend to conduct QE forever. If the market is convinced that QE is forever, it will be more complex for the ECB to engage in tapering: think about the Fed tapering in 2013.

And he adds:

The question here is how a central bank can communicate about the end of a monetary policy tool. If a central bank embarks on a quantitative easing programme, you would expect that the ways to end this programme have been discussed since the very beginning. If they have not, the central bank is either incompetent, irresponsible or short -term -focused … and you would not be happy with an incompetent or short -term -focused central bank.

The US Federal Reserve obviously failed its taper communication in the middle of 2013. We hope that the ECB will manage its better.

Sometimes, markets act with the rationality of a two-year-old child ; the ECB has no choice but to act accordingly.