Rising bond yields put ECB’s nerves to the test ahead of tapering decision
Borrowing costs for eurozone governments are rising again, straining the nerves of European Central Bank policymakers before they decide whether or not to slow its asset purchases from next month.
If the ECB cuts its bond purchases from its recent pace of just over € 80 billion in net purchases per month at its next Governing Council meeting on June 10, it will join other central banks which have already done so in response to a better economic outlook, including in Canada and the UK.
U.S. Federal Reserve officials discussed whether to start talking about reducing its bond purchases at a meeting in late April.
But the recent rise in bond yields underscores how cautious the ECB will need to be in pulling out of its emergency stimulus efforts if it is to avoid an unwanted increase in funding costs for some of the weaker economies in the bloc. .
In response to a question on Friday on whether the ECB would slow down its bond purchases, its president Christine Lagarde said it was “far too early and that it is actually unnecessary to debate the issues any longer. term”.
“I have said on several occasions that policymakers must provide the right bridge through the pandemic, well before the recovery, so that we can actually fulfill our mandate, and that is what we will do,” added Ms Lagarde. .
The withdrawal of monetary stimulus after a crisis is a balancing act. Do it too quickly and it can scare off investors, jeopardizing the recovery. But do it too slowly and the economy can overheat, making it more painful to tighten policy later.
“It’s a magic trick,” said Paul Diggle, deputy chief economist at Aberdeen Standard Investments. “If Lagarde can handle the communications being very reassuring, then maybe she can keep this from being called a downturn and the sale escalating.”
The more conservative ‘hawks’ on the ECB board have been pushing for weeks to slow the pace of bond purchases, arguing this is justified by an improvement in growth and inflation prospects which should be reflected in the latest forecast from the central bank next month.
However, some more “accommodating” board members have repulsed, calling on the ECB to maintain the stimulus at least until the economy has fully recovered from the pandemic and inflation has risen sustainably in line with its target.
A board member said the ECB was unlikely to slow down its bond purchases because investors were overreacting to fears of rising inflation, which the central bank said will only be temporary, adding, “We don’t want to encourage this by sending a signal with a slowdown in buying. ”
The ECB’s move is complicated by the recent drop in government bond prices, which took the GDP-weighted average 10-year yields in the euro area to 0.27%, the highest since June of the year last.
This move is partly due to rising German borrowing costs – a benchmark for the rest of the euro area – from very low levels since the start of the year, as investors reacted to improving prices. perspectives.
Germany’s 10-year yield was a relatively high minus 0.12 percent on Friday. Goldman Sachs analysts expect the return to turn positive later this year.
The challenge for the ECB will be for it to commit to maintaining “favorable financing conditions” – preventing borrowing costs for households, businesses and governments from overtaking the economic recovery.
The ECB responded to the last significant jump in eurozone bond yields earlier this year by committing to buying bonds at a “significantly higher pace” in the second quarter.
But at that time, the eurozone was still weighed down by coronavirus containment measures and the central bank viewed the rise in bond yields as an unwarranted overflow from the United States, which was recovering faster due to a $ 1.9 billion fiscal stimulus plan.
Investors now believe the European bond market is fueled by more genuine signs of recovery. “There was a bit of pessimism in the outlook for the euro zone at the start of the year,” said Mohammed Kazmi, portfolio manager at Union Bancaire Privée. “Now, with the acceleration of immunization programs, we are seeing a catch-up to the optimism already reflected in the United States.”
Brighter growth prospects dampen the appeal of ultra-safe assets like German government bonds. Inflation expectations have also recovered, both at home and abroad.
Germany’s 10-year break-even rate, a measure of market-based inflation expectations, stands at 1.41 percent, down from less than 1 percent earlier this year. While that figure is still well below the ECB’s target of just under 2 percent, it does mean that real yields – adjusted for inflation – have remained stable despite the bond market sell-off.
Not covered – Markets, finances and strong opinion
Robert Armstrong dissects the most important market trends and explains how the best minds on Wall Street are responding to them. Register now here to receive the newsletter directly in your inbox every day of the week
Katharina Utermöhl, economist at Allianz, said that rising inflation expectations make it more likely that the ECB will “let go a bit” by slowing bond purchases between the pace of the first and second quarters, adding that this will continue. be “a communication challenge”.
The risk is that the ECB will accelerate a recent rise in borrowing costs for weaker, more indebted economies – the so-called eurozone periphery. Italy’s 10-year yield hit an eight-month high of 1.16 percent on Wednesday. The extra yield, or spread, that Rome is paying relative to Berlin on 10-year debt hit its highest since January.
“It’s easy for hawks to say that this is all part of a healthy recovery in inflation expectations and that the absolute level of returns is still low,” said Frederik Ducrozet, strategist at Pictet Wealth Management. “But when you talk about the risk for the recovery, you have to look at the peripheral spreads.”