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Don't call it tapering. It's only lower, but longer

The ECB has announced a reduction in its quantitative easing, while insisting this must not be called tapering. No wonder it took a while for markets to digest the news.

The problem with continuously firing away at a problem is that eventually, you start running low on ammunition. That seems to be the point the European Central Bank (ECB) has now reached. Superficially, its monetary-policy decisions look like an early Christmas gift of the sort markets have come to expect.

Quantitative easing will be extended, and not just until September 2017 as we and most others in the market had expected. Instead, the ECB will keep on buying “until the end of December 2017, or beyond, if necessary. If, in the meantime, the outlook becomes less favorable”, due, for example to worsening financial conditions, its statement also leaves the door wide open to “increase the programme in terms of size and/or duration.”

All this was, however, undercut a little by the reduction in the monthly pace of purchases from €80bn to €60bn from April onwards. In the press conference, ECB President Mario Draghi went out of his way to provide reassurance. There was a broad consensus, according to Draghi, and: “Tapering has not been discussed.“ The message, in the face of next year’s presidential election in France and political turmoil in Italy is that the ECB is staying the course and will be there for as long as it takes.

Of course, December 2017 is still some way off. The ECB’s staff projections for inflation were pretty subdued, at 1.3% for 2017 (large thanks to year-on-year increases in the oil price) and still expected to rise to only 1.7% by the time Draghi leaves office in 2019. As Draghi helpfully pointed out, 1.7% is not really close to 2%, thus hinting the ECB might need to do more to reach its mandate of inflation rates of below, but close to, 2%. Naturally, the ECB will have plenty of opportunities next year to update both its language and its projections ahead of next fall’s German elections.

In the meantime, there are three takeaways investors should keep in mind.

First, they should not overlook several important changes in the modalities in the ECB’s asset-purchase program. Notably, the minimum time to maturity for eligible bonds has been reduced from 2 to 1 year, while purchases of bonds yielding less than the deposit rate will now be possible. This is a reminder that the ECB is acutely aware of the scarcity its purchases have already caused. To get the programme prolonged, Draghi needed to both change the criteria and reduce the monthly amount. Doing even more would be technically hard – as Draghi admitted when asked about raising issuer limits. (He rightly pointed to the many legal headaches this would have caused.)

Second, the ECB is still able to provide markets with a modest boost, when it decides to put the most dovish spin on its decisions. Given the constraints it faces, however, the emphasis is increasingly on modest, rather than boost.

Third, and perhaps most importantly, the world has changed since March 2016. Deflation fears have receded, as Draghi himself mentioned when pressed on the cut in monthly purchases to €60bn, and the U.S. has elected a new president.

Markets have further moved away from the record lows seen after the Brexit vote and particularly since the last ECB council meeting on October 20th:

  • 10-year German Bund yields have moved into positive territory, adding 0.33% yield.

  • U.S. 10-year Treasuries even gained 0.6%.

  • That compares to an increase of medium-term inflation expectations of 0.37% for the U.S. and 0.25% for the Eurozone (using average expectations over the five-year period that begins five years from today).

  • While Spanish spreads hardly moved, Italian spreads widened by 13 basis points (bps), after having peaked just before the referendum.

  • Spreads on euro investment grade (IG) and high yield (HY) widened by 41 bps and 35 bps respectively.

  • Despite high volatility, the euro only lost 1.5% to the U.S. dollar in that period.

  • The spread between 2-year Treasuries and 2-year German government bonds has reached a 16-year record, which we view as strongly supportive for the U.S. dollar.

The ECB’s statement confirms our view that we probably have seen the lows in Eurozone’s sovereign-bond yields in 2016 but that we should not expect a bond sell-off in 2017. The ECB has largely confirmed our and market’s dovish view, even if in terms of the specifics, it is now buying less, but for longer. We maintain our year-end 2017 targets of 0.6% for the 10-year Bund yield, 2.5% for 10-year U.S. Treasuries and parity for the EUR/USD.

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