With the eurozone economy now on a firmer footing, the focus has shifted toward how the European Central Bank (ECB) will navigate its exit from unconventional monetary policy.
Faced with the possibility of deflation taking hold in the eurozone, the ECB adopted a negative interest rate policy in 2014 and launched a full quantitative easing program the following year. But now that the eurozone economy is strengthening and policymakers have acknowledged deflation risks have disappeared, there are a growing number of questions about the need to keep monetary policy measures so easy.
To a certain extent, the ECB has already started taking its foot off the accelerator. In March, the central bank offered its final round of low-cost loans to banks in a program known as the targeted longer-term refinancing operations. Then, in April, the ECB reduced the pace of its monthly bond-buying program by €20bn to €60bn. So what happens next?
Tapering to begin in September?
There is an expectation that the ECB will announce a rapid tapering of its bond-buying program this September. But while markets see a fast tapering scenario as negative for eurozone government bonds, fixed income could find support as the pace of reduction is likely to be slower than anticipated.
Investors are also taking for granted the announcement will come in September, but again, they may end up being disappointed. We believe it is more likely the ECB waits until October’s meeting. Inflation is of no concern and the German election occurs September. This, in turn, pushes any potential rate hike back further to 2019.
Another possibility is that the ECB takes a more aggressive approach. This could involve reducing its bond-buying program quicker each month or even raising interest rates before quantitative easing ends. Either scenario – or a combination of both – would likely put yields on eurozone government bonds under pressure. However, such an outcome could also generate opportunities. In particular, there is the potential for a steady appreciation of the euro and the relative outperformance of the financials sector within credit markets.
Do not forget the ECB targets inflation
To determine which option the ECB might choose, it is important to assess the underlying dynamics of the eurozone economy. While eurozone growth has accelerated and unemployment is falling, inflation remains weak, and it is unlikely to move sustainably close to its target for at least another two to three years.
It is also important to remember that the ECB targets inflation, not growth. As inflationary pressures remain weak, we expect the ECB to cautiously withdraw stimulus, with no rate hikes for the foreseeable future. A rapid, Fed-style taper that some market participants are anticipating with quantitative easing ending by the middle of next year is therefore unlikely.
Kenneth Orchard is global fixed income portfolio manager at T. Rowe Price