Borrowing costs for eurozone governments are rising again, testing the nerve of policymakers at the European Central Bank ahead of their decision on whether to slow its asset purchases from next month.
If the ECB does dial down its bond-buying from its recent pace of just over €80bn in net purchases per month at its next governing council meeting on June 10, it will join other central banks that have already done so in response to a better economic outlook, including in Canada and the UK.
Officials at the US Federal Reserve have discussed whether to start talking about tapering its bond purchases at a meeting in late April.
But the recent rise in bond yields underscores how carefully the ECB will need to tread as it backs off from its emergency stimulus efforts, if it wants to avoid an unwelcome rise in funding costs for some of the bloc’s weaker economies.
In response to a question on Friday about whether the ECB would slow its bond purchases, its president Christine Lagarde said it was “far too early, and it’s actually unnecessary to debate longer term issues”.
“I have repeatedly said that policymakers need to provide the right bridge across the pandemic, well into the recovery, so that we can actually deliver on our mandate, and that’s what we will do,” Lagarde added.
Withdrawing monetary stimulus after a crisis is a balancing act. Do it too fast and it can spook investors, putting the recovery at risk. But do it too slowly and the economy can overheat, making it more painful to tighten policy later.
“It is a magician’s trick,” said Paul Diggle, deputy chief economist at Aberdeen Standard Investments. “If Lagarde can manage the communications by being very reassuring then maybe she can avoid this being called a tapering and causing the sell-off to deepen.”
The more conservative “hawks” on the ECB council have been pushing for weeks to slow the pace of bond purchases, arguing this is justified by an improving outlook for growth and inflation that is likely to be reflected in the central bank’s latest forecasts next month.
However, some more “dovish” council members have pushed back, calling for the ECB to maintain stimulus at least until the economy has fully recovered from the pandemic and inflation has sustainably risen in line with its target.
One council member said the ECB was unlikely to slow its bond purchases because investors were overreacting to fears about rising inflation, which the central bank believes will only be temporary, adding: “We don’t want to encourage that by sending a signal with a slowdown in purchases.”
The ECB’s decision is complicated by the recent decline in government bond prices, which has lifted the GDP-weighted average of 10-year yields in the eurozone to 0.27 per cent, the highest since June last year.
The move has been driven partly by a rise in German borrowing costs — a reference point for the rest of the euro area — from very low levels since the start of the year, as investors respond to an improving outlook.
Germany’s 10-year yield was a relatively lofty minus 0.12 per cent on Friday. Goldman Sachs analysts predict that the yield will turn positive later this year.
The challenge for the ECB will be that it has committed to maintaining “favourable financing conditions” — preventing borrowing costs for households, businesses and governments from outpacing the economic recovery.
The ECB reacted to the last significant jump in eurozone bond yields at the start of this year by committing to buy bonds at a “significantly higher pace” during the second quarter.
But at that time, the eurozone was still weighed down by coronavirus containment measures and the central bank viewed the rising bond yields as an unwarranted spillover from the US, which was recovering faster due to a $1.9tn fiscal stimulus package.
Now, investors think Europe’s bond market is driven by more genuine signs of recovery. “There was quite a bit of pessimism in the eurozone outlook at the start of the year,” said Mohammed Kazmi, a portfolio manager at Union Bancaire Privée. “Now with the vaccine programmes accelerating we are seeing a catch-up with some of the optimism that’s already priced in in the US.”
Brighter growth prospects dim the appeal of ultra-safe assets like German government bonds. Inflation expectations have also picked up, both at home and abroad.
The German 10-year break-even rate, a market-based measure of inflation expectations, stands at 1.41 per cent, up from less than 1 per cent earlier this year. While that is still well below the ECB’s target of just below 2 per cent, it means that real yields — adjusted for inflation — have remained flat despite the bond market sell-off.
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Katharina Utermöhl, an economist at Allianz, said higher inflation expectations make it more likely that the ECB will “take its foot off the pedal a bit” by slowing bond purchases to between the pace of the first and second quarters, adding that this will still be “a communication challenge”.
The risk is that the ECB could accelerate a recent rise in borrowing costs for weaker, more indebted economies — the eurozone’s so-called periphery. Italy’s 10-year yield hit an eight-month high of 1.16 per cent on Wednesday. The extra yield, or spread, that Rome pays compared with Berlin on 10-year debt hit its highest since January.
“It’s easy for the hawks to say this is all part of a healthy recovery in inflation expectations, and that the absolute level of yields is still low,” said Frederik Ducrozet, a strategist at Pictet Wealth Management. “But when you talk about the risk to the recovery you have to look at peripheral spreads.”
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