© Reuters. The complete Europa series, with the new 100- and 200-euro banknotes, is displayed during a presentation at the ECB headquarters in Frankfurt, Germany, September 17, 2018. REUTERS/Kai Pfaffenbach/File Photo/File Photo
By Mike Dolan
LONDON (Reuters) – If you’re waiting for the imminent end of central banks’ bond buying “quantitative easing” – make sure you’re sitting comfortably. The European Central Bank could well throw another $1 trillion log onto the fire as soon as this week.
As government borrowing rates sank across the world this week and stocks shivered, it appeared as if markets were having second thoughts about the long-held assumptions about the end of pandemic lockdowns, searing economic rebounds and widespread reflation.
COVID headlines this month have certainly given investors plenty to ponder, even if a complete rethink of vaccine-led recoveries still seems unnecessary.
But possible signals from Thursday’s ECB policy meeting could be just as big a culprit behind the gloomy reading coming from world bonds. Another post-pandemic wave of bond buying looks likely in Europe, inevitably spilling through other markets even as other central banks start to gradually wind down emergency COVID-related stimuli.
Much like the Federal Reserve did last year, the ECB this month announced changes to its long-term strategic goals sooner than many had been expecting. While not fully apeing the Fed’s move to an average its inflation target over time, it did make what looked like small tweaks but which could have huge bond buying implications.
On July 8, the ECB shifted its inflation target to 2% from “below but close to 2%” and accepted the inflation rate could temporarily deviate above or below.
Hardly seismic on the face of it. But when you realise the ECB’s own inflation forecast for as far away as 2023 is just 1.4% – even after its massive 1.85 trillion euro pandemic bond buying plan (PEPP) expires next March – then you see how much work it still has to do to make that 2%.
This week it plans to shift its policy guidance to reflect that new strategy – with ECB chief Christine Lagarde insisting ECB policy needs to be “especially forceful and persistent” when interest rates are already below zero.
For ECB-watchers, that underlines the fact that the ECB now sees bond buying as its main policy tool and will use that forcefully and continually until it meets its goals.
For a central bank that briefly hiked interest rates in 2008 amid one of the biggest banking crashes in modern history – and repeated the error in 2011 as the euro sovereign debt crisis unfolded – the lesson of premature tightening has been learnt the hard way.
So if the PEPP is left to expire in March – assuming the pandemic does actually end by then – that “force” will have to be applied to its standing Asset Purchase Programme (APP) that was in place before the pandemic but is still running alongside the PEPP at just 20 billion euros a month.
Katharine Neiss, chief European economist at asset manager PGIM Fixed Income, reckons the issue is now one of ECB credibility as it fights years of sub-target inflation expectations.
“Its future effectiveness as an institution relies on backing its talk with the policy walk,” she said.
WALK THE TALK
Neiss said she sees APP purchases expanded as much as four-fold to as high as 80 billion euros per month after March.
That would equate to an additional 720 billion euros over 12 months to March 2023 – similar in magnitude to the asset purchase announcement made at the height of the pandemic in March 2020 and equivalent to a third of all the assets the ECB has bought since 2014 to date.
And that tally assumes euro zone inflation is sustainably 2% by March 2023. If it’s not, another three months of that would top the $1 trillion mark – or a trillion euros more within six months of that.
Right now the market certainly doesn’t see inflation at 2% over that horizon. The euro 5year/5year forward inflation swap is still stuck just above 1.5% – the main market-based indicator of long-term inflation expectations – and hasn’t peeped above 2% since 2014.
But neither did forecasters see this policy shift coming. Only last month, the ECB’s own survey of analysts expected the PEPP to be ended in March and the APP left unchanged.
To be sure, reports of splits within the governing council mean such forceful guidance may yet face resistance. And some expect the ECB to wait for new forecasts in September before being more specific.
PIMCO Portfolio Manager Konstantin Veit reckons this week’s meeting will simply discuss necessary tweaks to ECB language on interest rate guidance and its framework. In September, he sees a more modest “upsizing” of the APP to 60 billion euros a month as the PEPP ends with progress on inflation still “meagre”.
Despite criticism of QE in other countries, there’s little doubt that the ECB itself sees asset purchases along with negative interest rates and forward guidance as effective tools to lift inflation. A working paper published by the ECB last month concluded that euro zone inflation would have been 0.75 percentage points lower than the 1.3% recorded in 2019 if those tools had not been adopted over the previous 6 years.
But for world markets at large, an additional trillion dollars or even euros worth of bond buying by at least one of the “Big 4” central banks over the next two years can well be viewed as yet another supply shock of sorts.
With the ECB already buying far more bonds than the governments’ underlying fiscal deficits are creating, the long-standing shortage of “safe assets” needed by banks, pension and insurance funds is likely to see considerable overspill elsewhere – weighing on bond yields everywhere.
Even if the Fed does start to taper its QE, the ECB doesn’t look like it’s going anywhere for a long time.
(by Mike Dolan, Twitter: @reutersMikeD. Charts by Saikat Chatterjee. Editing by Jane Merriman)