The Council of the European Central Bank pulled an impressive stunt at the monetary policy meeting on 26 October. ECB President Mario Draghi announced to reduce the extremely supportive monetary policy in the near future while sounding very cautious (dovish) with regard to the process at the same time.
In response, the euro depreciated against the US dollar, share prices increased, and the yields of German government bonds and spreads for country default risk were down.
Reduction of the bond purchase programme
The most important measure is the reduction of the bond purchase programme. Until the end of 2017, the monthly volume will remain at EUR 60bn. From January 2018 onwards, it will be halved to EUR 30bn and is to run at least until September 2018.
Optimism about economic development
The backdrop for this measure is the growing optimism of the ECB about a gradual increase in inflation towards the central bank target of slightly below 2% in the medium run. Three reasons were cited: 1) economic growth in the Eurozone is robust and broadly based; 2) core inflation has already edged slightly higher (1.1% p.a. in September); and 3) the monetary policy is effective by keeping credit interest rates low.
Cautious course of action
However, economic growth is still not self-supporting, and inflation pressure is low. Therefore, a high degree of monetary support remains necessary.
Ongoing monetary support
The forward guidance, i.e. the guidance of the market participants’ expectations, is an important tool used by the central bank. In the press statement, three rules seem to apply: 1) supportive level, 2) only gradual reduction, 3) no abrupt termination.
The balance sheet of the ECB has already grown to EUR 4,400bn. In September 2014, it was still at EUR 2,000. The volume of liquidity that the ECB provides to the system is therefore massive.
The bond purchase programme will be extended until September 2018, albeit in a reduced form. If necessary, it will be extended again or even expanded. The expiring bonds will be reinvested also after the end of the bond purchase programme for as long as necessary.
The key-lending rates will remain on the currently very low level after the bond purchase programme has come to an end. This puts paid to any expectations of higher key-lending rates in 2018. An initial increase in key-lending rates is now more likely to happen at the end of 2019.
Economic growth in the Eurozone is strong and broadly based, but not self-supporting. At the same time, inflation is too low. This requires a moderate reduction of the very expansive monetary policy. In the short run, this environment is positive for risky asset classes such as equities. Even for credit-safe bonds such as German government bonds, the environment is not particularly disadvantageous. The risk premium for holding bonds with long as opposed to short maturities (term premium) could increase as a result of the expiry of the bond purchase programme, but the outlook for sustainably (very) low key-lending rates is supported by the variables of the scenario in place.
Unfortunately – and paradoxically – the susceptibility to (or risk of) price slumps is higher:
- An overheating economy could cause inflation to record an unexpectedly substantial increase. This would force the ECB to not only take the foot off the gas but in fact to hit the brakes.
- The TINA investment approach (“There Is No Alternative”) for risky asset classes could cause the financial market to overreach.
Prognoses are no reliable indicator for future performance.