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Fixed-Income Insights

Despite improving economic and political conditions, the European Central Bank is unlikely to reverse policy direction in 2017. 

 

In Brief

  • Recent economic and political developments have increased pressure on the European Central Bank (ECB) to reverse monetary accommodation.
  • However, investors who want to position their assets for a reversal of ECB policy may have to wait longer than they expect.
  • For one thing, recent readings on eurozone gross domestic product and inflation are below levels under which the ECB would begin to unwind its quantitative easing program.
  • Further, the ECB likely is wary of the potential political consequences of a policy-led pullback amid already meager economic growth in peripheral eurozone countries.
  • The key takeaway: Improving eurozone growth may lend support to asset markets, but the initial stages of an ECB monetary policy reversal are not likely to unfold soon. 

 

Improvements in European economic growth, voter rejections of populist candidates in recent elections, and higher headline inflation in the eurozone have increased pressure on the European Central Bank (ECB), and its president, Mario Draghi, to reverse monetary accommodation. On May 22, the president of Germany’s Bundesbank, Jens Weidmann, joined others in calling for an end to ECB stimulus, based on signs of a slowly strengthening eurozone economy. 

Such a policy reversal may involve important investment consequences.  Rising rates will affect European fixed-income investments, encourage a stronger euro, and influence the financial fortunes of many companies, particularly banks.  Rising eurozone interest rates also will affect investments elsewhere, as investors reassess fixed-income opportunities in the United States and among emerging markets.

But investors anxious to position their portfolios for a reversal of ECB policy may have to be more patient than they want to be.  Although eurozone gross domestic product improved, to 1.7%, during the first quarter of 2017, and headline inflation rose, to 1.9%, in April, these figures fall short of what the ECB requires in order to reduce its bond purchases under its quantitative easing (QE) program, let alone begin a process of rate normalization (that is, to begin hiking rates). 

Inflation Focus
Unlike the U.S. central bank, the Federal Reserve (Fed), whose dual mandate of full employment and price stability has largely been achieved, the ECB’s singular goal of price stability—defined as sustained inflation below, but close to, 2% over the medium term—is still out of reach.  Draghi and other ECB officials have repeatedly emphasized inflation over growth and core inflation (which excludes food and energy prices) over headline inflation.  Improvements to eurozone growth may at some point boost inflation, but at this point, acceleration in consumer and producer prices does not yet concern the ECB.

In each of the press conferences that have followed ECB policy meetings to date, Draghi has emphasized the distorting effect that year-over-year energy price increases have on headline inflation; instead, core inflation represents the central bank’s primary policy focus.  Core inflation has increased lately, but at 1.2% (according to the most recent April reading), it remains well below the ECB target of approximately 2.0%.

In contrast to those calling for policy reversal, Draghi remains clearly focused on the ECB’s goal, which underscores the pursuit of its current policy.  After the ECB meeting on April 27, he described the central bank’s decision, saying that “incoming data since our meeting in early March confirm that…underlying inflation pressures continue to remain subdued and have yet to show a convincing upward trend.”  He went on to say that low core inflation is expected to rise only gradually, even though it’s “supported by monetary policy measures and expected continued economic recovery,” which suggests a belief that continued QE is necessary to produce the ECB’s targeted level of inflation. QE seems unlikely to be modified until core inflation is not only closer to 2.0% but that it also will be, according to Drahgi’s speech on April 6, “self-sustained…even with diminishing support from monetary policy.”  Such criteria, we believe, are unlikely to come together until the first quarter of 2018, and could be delayed beyond that.

Political Caution
Other considerations seem likely to influence any adjustment to QE.  Because the ECB still sees downside risk to the eurozone economy, a reduction in bond purchases could increase the chances of an economic stumble.  With euroskeptic sentiment still alive and well in Europe, particularly in Italy, ECB decisions will seek to avoid the risk of stoking populist urges, or tilting an election, by compromising meager economic growth in peripheral countries.  The ECB does not want to be blamed for such an outcome and, therefore, seems likely to delay QE tapering and instead will proceed slowly before any tapering decision is firmly made.  External factors such as a negative economic impact as a result of Brexit, a slowdown in China, or U.S. “America first” trade policies could also temper an ECB taper program.

Even if there is not an economic stumble, a eurozone market reaction to QE tapering similar to the 2013 “taper tantrum” by U.S. investors could compromise monetary policy transition as well as fuel populist sentiment.  To avoid a repeat of the Fed’s experience with market fears of a premature winding down of policy accommodation, investors should expect a careful, deliberate introduction of the concept of ECB tapering, with a long lead time before inception of any reduction in ECB purchases, and outlining a well-publicized path for slow adjustments to avoid a dramatic market reaction.  The ECB may begin discussing the concept as early as September 2017, with inception in the first half of 2018, and a slow pace of purchase reduction, such that some QE purchases will be still active into 2019. 

Although economic strength in the eurozone, the victory of centrist candidate Emmanuel Macron in France’s presidential election, and increases in European headline inflation appear to justify tapering of QE, the ECB is unlikely to reverse policy direction in 2017.  An actual reduction in the €60 billion monthly purchase program will be dependent upon higher core inflation, eurozone economic risks, and external factors related to Brexit negotiations, China’s economy, and U.S. trade policies.  In the near term, improving eurozone growth, combined with relatively attractive valuation levels, may lend support to asset markets, but investors considering portfolio allocation changes based on potential consequences of a U-turn in ECB monetary policy may have to wait until next year.

 

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