Tapering? Be Careful What You Wish For

BoAML | What if the ECB were to start tapering too soon? Based on the ECB’s estimates for the impact of QE this would keep growth below potential and inflation below 1% much further down the line. The probability of deflation would actually be higher than of inflation reaching 2%. But this is not even a stable equilibrium. With higher rates and lower growth, concerns on the sustainability of public and private debt would likely resurface. On top of that, this scenario of persistent sub-1% inflation would contribute further to the unsustainability of debt and would perpetuate itself through its impact on inflation expectations. In other words, credit risk would likely be severely repriced and it is not clear whether there would be a market for the periphery. All of this without taking into account the complicated political outlooks across the board.

Tapering the tapering noise, take two

Bloomberg News, citing anonymous ECB sources, created substantial market interest last week with its tapering headline. The body of the piece was less spectacular though. According to those sources there was a near consensus in the Governing Council that once the ECB decides to start scaling down its stimulus, it would taper it rather than bring it to an abrupt end. This is no more than common sense, in our view. According to the same sources, the next instalment (i.e., after March 2016) could be at the current pace of EUR80bn. And this would hardly send a clear message on early tapering, we think.

What is more interesting about the article, in our view, is what is not mentioned. The option left out in that article is the possibility of upgrading QE. We do not expect an upgrade, but assuming these sources are correct, and taking into account the hawks’ communication offensive over the last few weeks, the debate has seemingly shifted from “more versus more of the same” to “less versus more of the same”.

We think this could be part of an effort by the ECB to manage down expectations ahead of the December meeting. A Reuters’ story last week signalled that the ECB would proceed with “tweaks” to QE in December rather than a big move. The risk though is that the communication gets out of hand and that the market links those news to some statements from the Governing Council that it is seemingly comfortable with undershooting the inflation target for longer and starts pricing an early exit by the ECB.

Given our outlook for inflation and growth, we think the ECB will actually maintain the pace of buying to EUR80bn per month for another 6 months at its December meeting. We revisit here the reasons why early tapering would damage the ECB’ credibility. We highlight two of them: first, giving the impression that implementation issues – largely the product of political constraints – would command the stance, thus giving out that the arsenal is empty. Second, allowing monetary policy to yield to a too tight fiscal policy, largely responsible in our view for the ultra-low level of interest rates.

 

The March package did not turn long-term interest rates negative

In a way, the ECB seems embarrassed by the success of its policy, considering that market interest rates have fallen even further than it would have expected upon launching QE. With 10-year Bund yields in negative territory, the central bank is dealing with intense clamouring that its policy is counterproductive. This is how we interpret Francois Villeroy de Galhau’s (Banque de France Governor) comments on rates having “touched their floor”, making it clear the central bank has no intention of pushing them lower.

Mersch’s comments this week echo this view when he said that “many consider that we have reached the “effective lower bound” or that it might be not that far from the current deposit facility rate of -0.4%…This level I would still deem to be “mildly negative” – but I would shy away from moving into “wildly negative” territory. Cutting interest rates even more would come with increasing risks as reactions to such cuts might not always be linear.”

However, we think the March package in itself did not push German 10-year yields into negative territory. This happened only in the run-up to the Brexit referendum. The market fled to safety in a more uncertain environment. Consensus Euro area GDP growth for 2017 was cut by 0.3% between March and September, and inflation by 0.1%. That German 10-year rates have fallen by a further 25bp in those circumstances should not be a total surprise.