Graph of the week

Graph of the week

17-05-2018 | インサイト

The ECB is set to normalize policy but how much time does it have?

  • Jeroen Blokland
    Portfolio Manager, Robeco Global Allocation team

After weeks of silence, the ECB has reaffirmed its intention to start normalizing monetary policy later this year. And for good reason. Growth is expected to remain solid for the foreseeable future and inflation is likely to pick up. This latest announcement by the ECB puts short-term rates back into play, potentially pushing up the yield curve as a whole. However, the window for normalization looks narrow.

ECB rate hike on the horizon

In a recent interview with Bloomberg, ECB policymaker Francois Villeroy signaled that he expects the central bank’s QE program to come to an end this year. He added that the first rate hike, which the ECB has stated will come “well past” the end of QE, could follow “at least some quarters, but not years” after that.

While Villeroy’s remarks weren’t overly revealing, as there is consensus that a first rate hike will probably happen within six to nine months after the ECB has terminated its QE program, the market reacted pretty strongly to the news. Obviously, this had something to do with the ECB’s recent silence on future policy at a time of peaking growth and disappointing inflation numbers. But the prospect of a ECB rate hike, something we have not experienced since the outbreak of the financial crisis back in 2008, also brings short-term yields back into play.


Unlocking short-term bond yields

Take, for example, the current -0.55% yield on Germany’s 2-year government bonds (shown above). This is even lower than the ECB’s -0.40% deposit rate. But, with a possible rate hike as early as the middle of next year, 2-year bond yields should start to reflect some kind of ECB normalization going forward. Any further confirmation of the ECB’s willingness to start lifting rates should unlock short-term bond yields as well.

If economic growth holds up in the coming quarters, and there is little reason to expect that it won’t, higher short-term yields will likely be accompanied by higher long-term yields. Certainly if inflation starts to rise. This has not happened so far, with headline inflation dropping to 1.2% and core inflation down to 0.7%, the lowest level in two years. But with oil prices up more than 50% year-on-year and wage growth finally starting to show up in underlying inflation data, this is about to change. Together with the prospect of policy normalization by the ECB, the entire yield curve looks set to move higher.

Narrow window

But how much time does the ECB have to reduce its extraordinary monetary measures? In the latest Bank of America Merrill Lynch fund manager survey, fund managers expect the next US recession to start during the second half of 2019 or first half of 2020. Typically, the Eurozone economy lags the US by approximately six months, but that would still give the ECB very little time to implement any kind of normalization. For the purpose of comparison, it took the Fed 2.5 years to hike its target rate from 0.25% to 1.75% – which is still historically low – and even longer to start actively unwinding its balance sheet. Lower rates and a bigger balance sheet means that the ECB will have to do more in less time to catch up with the US, something that the markets will not digest very well.

Even though an extension of the current economic cycle beyond 2020 looks feasible, it’s doubtful that the ECB will be able to normalize monetary policy in any way comparable to the US before the next downturn. Hence, rates will stay lower than may be expected based on inflation growth. At the same time, I would expect the ECB to reduce stimulus as much as possible without catching markets off guard. Barring a major economic shock, both short-term and long-term bond yields seem destined to rise.


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