Despite currency and protectionist risks, the European Central Bank (ECB) announced its plan to halt bond purchases by the end of 2018, striking fear into global credit markets that higher inflation and interest rates may eventually spread beyond the United States.
Marking the end of cheap money
In some ways, the ECB is following the path of the U.S. Federal Reserve, which stopped buying new securities near the end of 2014 after a prolonged period of injecting stimulus into a weakened economy.
After ending quantitative easing, or QE for short, the Federal Reserve kept its balance sheet stagnant for roughly three years to help maintain accommodative financial conditions. This past September, it started reducing its holdings in a process called quantitative tightening.
The ECB’s blueprint is similar at the outset, halting its boost to Eurozone money supply. But what comes next is still a mystery to many. The central bank has made no public mention of following a similar tightening path, only noting that interest rates are unlikely to budge until at least the fall of 2019, as it charts its course in more delicate conditions than those that faced its U.S. counterpart.
The difficulty of making policy that crosses countries
The ECB may only be dipping one toe in the water because it has to wade in many waters – spanning from the Baltic to Mediterranean Sea. Determining unified monetary policies for 19 nations with significantly different economic situations is not easy.
It must balance the varying inflation rates of its member nations to make sure isolated instability does that cascade across the Eurozone. Currently, the economic disparity is stark from north to south. Germany, France, and the Netherlands are experiencing generally high growth, while southern nations like Italy, Portugal, and Greece are dealing with monetary and political crises. These southern nations don’t currently have the capital (both political and fiscal) to implement fiscal policies to boost their economies as monetary stimulus ends.
The ECB’s hope is that a creative policy that ends bond-buying will appease pro-growth northern nations, but keep interest rates stagnant to avoid market turmoil in the south. It’s truly like trying to thread a needle – a hawkish approach to accommodative stimulus combined with a dovish approach to interest rates.
Forecasting the market impact
The policy posture is indicative of a global pattern. The ECB is ending QE just as the U.S. is in the active stages of quantitative tightening, and the Bank of Japan is starting to taper its bond-buying program. The G-3 central banks’ collective balance sheet increased by just $76 billion in the first half of 2018 after rising by $703 billion in the six months prior. This suggests that well over a half trillion dollars of liquidity has disappeared from the markets.1
This liquidity squeeze may loom large. Forecasts show that cross-border bond purchases may fall by more than half this year, perhaps putting even greater pressure on global yields than markets are pricing in.2 These global bond markets are heavily exposed to European investors, who bought up over half of U.S. net corporate issuance over the last four years thanks to debt shortages at home. Currently, Europeans hold almost 10 percent of the total outstanding stock of U.S. fixed-income securities, leaving the U.S. vulnerable to a wide-ranging shift in monetary policy.2
Now, as Europeans rotate their portfolios back home, will U.S. investors pick up the slack? With central banks no longer artificially manipulating the long-end of the Treasury market, medium- and long-term rates will revert to taking their cues from market supply and demand. U.S. bond supply is up as the Treasury department ramps up its issuance to fund growing deficits, and the Fed remains in sell mode. To entice demand, interest rates may continue higher, especially if positive growth and unemployment numbers continue.
Keep an eye on the fallout
For fixed-income investors, the downward pressure on global bond prices and upward pressure on yields may only intensify. They may consider looking outside a global bond market in flux for income with downside protection, but at the very least, they must monitor another central bank’s transition away from post-Recession easing to a new global normal.