LONDON (Reuters) – The European Central Bank is considering a downward spiral of volatile global markets to start reducing its huge holdings of bonds — as governments ramp up spending to respond to an energy crisis likely to trigger a recession.
The European Central Bank, which has bought 5 trillion euros ($4.9 trillion) in bonds over the past decade to raise low inflation, now finds itself battling a record high of 10% inflation.
In addition to interest rate hikes including the unprecedented move of 75 basis points last month, policy hawks want to start quantitative tightening (QT): reducing the European Central Bank’s bond holdings.
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European Central Bank President Christine Lagarde acknowledged this week that the discussion has begun and will continue.
The process may still be a long way off, and it will likely come after the European Central Bank rises to about 2% and is very gradual, but bond markets – sluggish due to aggressive interest rate increases globally, the energy crisis and the collapse of British bonds – are nervous.
“There is a lot at stake in the eurozone when it comes to QT,” said Benjamin Schroeder, chief interest rate strategist at ING, adding that the closely watched gap between Italian and German yields was the main focus.
“But other than the spreads, there are also concerns that further market volatility could be fueled, especially when government funding plans in the eurozone are exposed to the risks of a growing upside.”
At 2.35%, the German 10-year bond yield is up 250 basis points this year and the Italian bond yield is up by nearly 360 basis points – the biggest increase in decades.
Germany last month unveiled a €200 billion package funded through new borrowing to help cushion the blow from the energy shock. Bank of America expects the net supply of European government bonds to rise by nearly €400 billion next year, an all-time high and well over the €120-145 billion projected this year, influenced in part by the purchase of European Central Bank bonds.
“This consideration also makes practical implementation of the ECB much more difficult,” Bank of America said.
softly and smoothly
Analysts expect the ECB to first phase out the reinvestment of bonds maturing under its traditional bond-buying programme. That would cut its balance sheet by €155 billion “manageable” in 2023 and €300 billion in 2024, ING estimates.
Goldman Sachs estimates that bond markets should be able to absorb an annual breakup of €250 billion of those holdings. Ten-year bond yields in the top-rated countries will rise by only 6 basis points and 15 basis points in southern Europe.
Even if those holdings are dumped, analysts widely expect the European Central Bank to continue reinvesting under its Pandemic Emergency Bond Purchase Program (PEPP), which it turned to countries like Italy and Spain over the summer as a first line of defense for divergence. From the spread of the return they pay on the highest rating in Germany is considered “unjustified”.
Eric Owenyan, head of European pricing strategy at Morgan Stanley, estimates that PEPP redemptions will equate to about 151 billion euros next year.
“To some extent, ironically, PEPP flexibility is a way to continue to do QE while doing QT and could eventually lead to a tightening of margins,” he said, referring to the first half of next year.
ING said the final liquidation of PEPP’s holdings could add to balance sheet cuts in 2025 with a total value of €388 billion. Analysts do not expect the European Central Bank to speed up the process with direct bond sales.
How QT will be implemented is largely unknown in the same way that quantitative easing was a relatively new experiment.
The Federal Reserve has begun shrinking its $9 trillion balance sheet, and staff recently concluded that bond market pressures could complicate QT by amplifying its impact and raising interest rates more than expected.
The Bank of England’s plans to start QT in early October have been postponed until October 31 as it launched an emergency bond purchase program to stem the bond market rout triggered by the UK government’s September 23 announcement of a “mini-budget”.
“The lesson from the Bank of England is that basically, if you don’t have financial stability, there is no point in trying to pursue price stability,” said Pete Heinz Christiansen, chief analyst at Danske Bank.
The ECB’s big headache is the containment of bond spreads.
In addition to the PEPP reinvestment, it has also launched a new instrument, the Transmission Protection Instrument (TPI), under which it will buy bonds from countries experiencing an “unjustified” widening of spreads over Germany.
Alliance Bernstein portfolio manager Nick Sanders said he was “skeptical” how the European Central Bank would achieve Qt through these safeguards.
“If you have yields in the eurozone backed by the support that they have, it will be very difficult for them to move into a QT environment without a shock to the marginal spreads, especially Italy.”
Annalisa Piazza, an analyst at MFS Investment Management, said the ECB could also find itself taking over QT during a recession, which could lead to an “excess” of policy.
There is no doubt that the European Central Bank, whose assets rival the Fed, adding to the global balance sheet runoff will be another source of uncertainty for the broader markets.
The rough rule, said strategists, is that $1 trillion in QT is consistently equal to about 10% of global stocks.
(1 dollar = 1.0306 euros)
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Additional reporting by Yoruk Bahceli and Dara Ranasinghe, and Samuel Indyk in London; Editing by Hugh Lawson
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