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European Taper Tantrum

2 November 2016 by Mark Holman

One of the developing themes in capital markets has been the overall worry of the removal of the extraordinary stimulus from Central Banks that has served so well to underpin asset prices around the globe.

In the US the FOMC are leaning towards their second rate hike in December, here in the UK Carney has told markets that the MPC is not insensitive to the fall in £ and therefore dampened hopes of another rate cut, then in Europe there were rumours that the ECB at some point may taper their €80bn monthly purchases. All this has come at a time when the global economic data has shown some modest signs of improvement in Q3, and in the UK in particular some very strong signs of rising inflation ahead. No wonder risk free bond markets have seen upward shifts across the yield curves.

Whilst all these fixed income markets are indeed heavily correlated, the various economies in question are at very different stages in their cycles. For today’s discussion I would like to focus on the ECB and what they might do in relation to their own stimulus programme, which is in place until at least the end of March 2017. Will they roll the programme as it is, will they alter the ‘modalities’, or will they indeed taper? The latter has certainly spooked the European government bond market in recent weeks and has the potential to spill across all capital markets. There is no need to remind everyone that a change in the risk free rate has widespread repercussions. So far that move has only been around 30 basis points in German Bunds, but they still only yield 14bp! So they have room to go higher if Draghi tapers or fluffs his lines at some stage.

So what will the ECB do at their next Governing Council monetary policy meeting on December 8th?

Firstly we would say that tapering is inevitable, eventually. In fact tapering is a necessity. QE is a tool that requires a central bank to control a large portion of the risk free assets in an economy, which by definition is generally a very large amount. By building a very large portfolio of these risk free assets they force other portfolios into different areas: either into longer duration (which flattens the yield curve) or into higher risking credit assets (which compresses credit spreads). The rationale for non-public sector QE is just to compress credit spreads faster and in a more meaningful way. In order for these policies to work the ECB requires large scale and therefore an amount of c€80bn a month has been designed to help them get there quickly and without totally distorting the market. Currently these policies have been working very well and have had the desired effects, from the ECB’s standpoint. So one can rationally argue that at some point €80bn a month is no longer needed. A smaller amount would still facilitate the squeeze. Draghi and his colleagues will have known this from the start. However, how can they begin to taper without causing a European ‘Taper Tantrum’? Draghi will have watched Ben Bernanke ‘shoot himself in the foot’ in May 2013, when his comments caused 10 year treasury yields to back up from 1.62% to 3% in just 3 months. This consequences of this move very rapidly fed into the real economy and he was forced to backtrack. To some extent the ECB is trapped; how can they avoid a similar scenario?

Draghi has throughout his tenure as ECB President been a leader that has used education theory as a tool to direct markets. We have been happy scholars and continue to observe closely. Draghi has told us that the QE programmes will continue at least until their primary mandate is in sight. From what we are seeing the economic improvements remain slight, and the inflation target seems well adrift, so there is no need to pull back the stimulus today. In fact, the back up in yields that fixed income markets have experienced recently, should help Draghi to seize an opportunity to grow his portfolio of assets and explain the rationale for tapering that will eventually come. Consequently, we think that Draghi will announce an extension to the asset purchase programme at the December meeting, perhaps with some modality changes, but at this stage not taper the volumes. He should however grab the moment to explain how the portfolio effect will eventually need lower monthly purchases …in the future. If he does not take this opportunity soon, he may not have another chance to avoid a Bernanke moment. Additionally, it will need to be the perfect speech to create the right balance. Not easy at all! The recent market reactions in Europe have therefore been completely rationale, and once again we await another key Draghi moment.

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