ECB to reduce QE from April 2017 - J.P. Morgan Asset Management
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ECB to reduce QE from April 2017

Contributors Michael Bell, Global Markets Insights Strategy Team
What was announced?
  • The European Central Bank (ECB) has kept interest rates on hold, with the deposit rate still at -0.4%.
  • It will continue with its quantitative easing (QE) programme at a pace of EUR 80 billion a month until the end of March. It will then reduce purchases to EUR 60 billion a month, with the option of increasing the monthly amount again, if necessary. The purchases are to continue until at least December 2017.
  • From January, it will reduce the minimum maturity of government bonds that can be purchased from two years to one year.
  • In addition, from January, it will be able to buy bonds with a yield below the -0.4% deposit rate, if required.
  • Real GDP is forecast to be at 1.7% in 2017, 1.6% in 2018 and 1.6% in 2019.
  • Inflation is forecast to rise to 1.3% in 2017, 1.5% in 2018 and 1.7% in 2019.
Successfully steepening the curve and weakening the euro

The ECB has decided that the risk of deflation in the eurozone has “largely disappeared.” As a result, it has decided to reduce the amount of QE purchases to EUR 60 billion a month. ECB president Mario Draghi was at pains to stress that the central bank does not view this as the start of ECB tapering, which he defined as purchases gradually reducing to zero. Tapering, so defined, wasn’t discussed by the ECB and is apparently not even “on the table.” The other option on the table was to continue at EUR 80 billion a month but only until at least September 2017.

So, why the reduction in the amount of purchases but over a longer guaranteed period, if this isn’t the start of a gradual withdrawal from QE? The ECB argues that it only originally increased purchases to EUR 80 billion a month because of increased deflation risks, and is now merely returning to the amount of purchases it previously deemed necessary, given that those risks have now dramatically reduced. The ECB now expects inflation to rise to 1.7% in 2019, close to its target. When asked whether 1.7% in 2019 was good enough, Draghi responded “not really…we have to persist.” The question now becomes whether QE will be further reduced in 2018.

The other key decision was the removal of the restriction on buying government bonds with a yield below the deposit rate. This is important because it increases the pool of bonds that are eligible for purchase, thus reducing concerns that the ECB will run out of bonds to buy.

The main unspoken intention of this announcement was probably to steepen the yield curve and weaken the euro—both desirable outcomes as far as the ECB is concerned. Following the announcement, the removal of the restriction on purchasing bonds below the deposit rate led to falls in short maturity yields. An increase in the gap between the yield on short-term European bonds and US bonds was negative for the euro. Meanwhile, the announcement of a reduction in the amount of monthly purchases of bonds led to higher yields for longer maturity bonds. This is desirable because extremely low mid- and long-maturity bond yields hinder the profitability of European financial institutions. European financials duly rallied on the back of the announcement and the subsequent steepening of the yield curve.

Investment implications
  • By removing the deposit rate floor, the ECB is likely to keep short European bond yields very low. If the Federal Reserve goes ahead and increases interest rates in the US over the coming years, as expected, this could place further downward pressure on the euro.
  • The ECB’s willingness to see the yield curve steepen, while keeping short-term rates very low, could potentially continue to support European financial equities.
  • A weaker euro could also support European exporters.
  • Core European government bonds continue to offer unattractive yields and could face further upward pressure on yields as speculation of a further decrease in purchases in 2018 mounts throughout next year, despite the ECB’s insistence that this is not the start of a gradual reduction in QE to zero.

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