A report published by Bloomberg in early October electrified the market. 1 It said that a consensus had formed within the European Central Bank (ECB) on the gradual phasing-out (tapering) of the bond-purchase program. This sparked memories of May 2013, when U.S. Federal Reserve Chairman Ben Bernanke informed Congress that the U.S. central bank was considering reducing its bond purchases. This resulted in enormous fluctuations in bond prices and a rise in yields. In the Eurozone, in contrast, the bond-market response in early October was brief and cautious. It soon became clear that the ECB did not want a rapid and sharp rise in interest rates. The reasons for this appear obvious.
The Eurozone's recovery from the consequences of the financial and economic crisis has been slower than in the U.S. For example, the Eurozone was not able to overcome the 2008/2009 decline in gross domestic product (GDP) until a year ago in 2015. The U.S. economy had achieved this in 2011 and introduced tapering just two years later. The core inflation rate in the U.S. at the time of the tapering announcement in May 2013 was 1.7 percent, 0.9 percentage points higher than in the Eurozone today. So the ECB could continue to take its time. Factors in favor of beginning tapering in 2017 include an increase in inflation as well as actual growth exceeding the Eurozone's potential growth. The profitability of the banking sector, which is reduced by quantitative easing (QE), low interest income for insurers and savers, as well as shifts between equity and debt in companies are additional arguments for tapering.
There is another reason why the ECB needs to think about tapering. There may not be enough German government bonds available given the existing purchase rules. So far, the ECB can only buy bonds with yields above the deposit rate of -0.4 percent and can only hold 33 percent of the individual government bonds' volume. A change in these levels may only provide a temporary solution to the bond shortage because the ECB has to weight its government-bond purchases based on its ownership structure. With a share of 26 percent, Germany is the main owner of the ECB, which only exacerbates the shortage of German government bonds.
This may make tapering inevitable. However, the central bank has to keep in mind the high debt levels in the peripheral countries. A sharp rise in interest rates could place new economic burdens on Italy, Spain and Portugal. Unemployment would likely rise again after governments had successfully reduced the high levels seen in these countries since 2013. At the same time, the ECB's inflation target of two percent would grow more distant. This makes countermeasures necessary to prevent a taper tantrum, i.e. a sharp rise in interest rates in response to lower bond purchases.
In choosing countermeasures, the key interest rate has traditionally been the first place to look. But this rate is negative. Even more negative key interest rates mean rising penalty payments for banks that keep excess reserves at the ECB. This could ultimately weaken the banks' equity base and thus their scope for lending, something that is not desirable. A more promising approach is the allocation of additional tenders to banks at favorable conditions (TLTROs). These long-term low-interest loans provided by the ECB are aimed at promoting lending to companies. But banks could also use the TLTRO funds to buy government bonds, which could limit the rise in interest rates as QE expires.
These are not the only tools the ECB has at its disposal. If, contrary to our expectations, economic activity in the Eurozone should weaken, the ECB could re-start its securities purchases, with a focus on bank bonds, structured bonds or equities instead of scarce government bonds. After the start of tapering, the ECB still has many options to manage interest rates in the money and capital markets. Given moderate growth and low inflation, we assume that the ECB is likely to continue to ensure just moderate interest-rate increases in 2017.
Source: Thomson Reuters Datastream; as of 11/9/16
In the U.S., the May 2013 announcement of tapering resulted in an increase in yields. In the Eurozone, a discussion about tapering began in October 2016. Yields rose only slightly.
Sources: European Commission, Thomson Reuters Datastream; as of 11/9/16
In many countries, unemployment rates are currently above their pre-crisis levels of 2008. This has led to expectations that the ECB may continue to keep yields low.