While the past six months have been all about politics, the last two weeks have been all about the central banks. As widely expected, on December 14, the U.S. Federal Reserve (Fed) hiked policy rates by 25 basis points (bps) or 0.25%, taking the federal funds rate range to between 50 and 75 bps. However, markets were a bit surprised by a different increase, the number of further hikes envisioned by members of the Federal Open Market Committee (FOMC) in 2017. The FOMC’s statement mentioned three potential increases, up from their previous estimate of two increases.
By contrast, on 8 December, the European Central Bank (ECB) announced the asset purchase program (APP) would be extended from April 2017 to December 2017, but at a reduced pace of €60 billion a month. Markets had been expecting a six-month extension at a continued pace of €80 billion a month, and immediately interpreted the ECB’s decision as equivalent to the Fed’s move to gradually “taper” asset purchases in 2013 that had so unsettled markets. However, ECB President Draghi attempted to reassure markets by refusing to call it tapering, and instead highlighted that the decision showed the ECB’s determination to keep monetary conditions very accommodative for a longer period of time.
Slower for longer
How does the ECB’s policy differ from tapering? The difference between the two can be explained by a basic contrast: slope versus steps. The U.S. 2013 taper steadily decreased purchases until they hit zero. The ECB’s latest decision to make asset purchases slower for longer is a staircase down to zero. Presumably, the ECB will announce in mid to late 2017 that, from January 2018, they will be extending asset purchases again, but this time at a reduced pace of, say, €40 billion a month, with this pattern continuing until asset purchases finally hit zero.
The ECB’s method of tapering implies that they will remain in the market for a long time yet and means that the market doesn’t currently have to worry about the eventual full withdrawal of monetary stimulus. Expectations for the first rate hike have been moved slightly further out and after rising slightly, 10-year German bund yields have rallied since, unlike with the 2013 U.S. “taper tantrum,” markets don’t think the ECB is making a policy mistake and they have bought into the idea that rates are set to remain low for a long time.
Compare this to what has happened since the Fed decision. The rise in the Fed’s median rate forecast for 2017 means that, while still gradual, U.S. monetary tightening will be slightly faster than originally expected. This has triggered a further sell-off in the U.S. bond market, with yields on 10-year Treasurys pushing above 2.6% for the first time since 2014. The divergence between the paths of the Fed and the ECB is very clear when you look at the difference in yield between U.S. and European sovereign debt.
The macroeconomic backdrop justifies this divergence in monetary policy. In the euro area, the output gap is wider, inflationary pressures are weaker – indeed, the ECB’s own forecasts show that inflation will remain below the 2% target into 2019. With so much spare economic capacity, it has been harder for the ECB to generate growth and, as a result, it has to maintain asset purchases for a longer time.
By contrast, the U.S. economy is approaching full capacity. The U.S. labour market is almost back to full employment, and while inflationary pressures are still muted, they are building. The ECB can only wish they were in a similar position. Throw into the mix a new fiscal stimulus plan from the President-elect Trump and the economic stars are aligning for the United States. As a result, the Fed has moved into the next stage of the monetary cycle, with rates set to go higher than previously expected and…to part ways with euro rates.
As I noted above, the spread between Treasurys and German bunds has widened drastically, but at 225 basis points, there could still be more to come. If you factor in the real (inflation-adjusted) growth rates of each economy and each central bank’s inflation target, it would be feasible to see that spread reaching a whopping 250 bps.
Another element of the ECB’s monetary policy program is the impact on the shape of the yield curve. Up till now, the technicalities of the APP had served to flatten the yield curve by forcing central banks to progressively buy more long-dated paper. However, the ECB has found that there are negative implications of flatter yield curves (see Is Monetary Policy Losing its Effectiveness). As a result, the ECB seems to have taken a page out of the Bank of Japan’s book. They’re looking to steepen the yield curve, and thereby helping banks, which are the cornerstone of the European economy. How has it done this?
The ECB has made some changes to the technicalities of its asset-purchase program, with one of the changes being a substantial broadening of the eligible universe of bonds for purchase. This means that the ECB could be buying substantially fewer long-dated bonds.
At the same time, another technical change – to allow purchases of bonds with yields below the deposit rate of -40 bps – encourages the purchase of short-dated bonds. The market impact of this will be to push down short-term rates, whilst pushing up long-term rates, i.e., steepening the yield curve.
Interestingly, this is in direct contrast to the Federal Reserve’s 2011/2012 monetary program “Operation Twist,” whereby the Fed sold short-term government bonds and bought long-dated Treasurys in an effort to push down long-term interest rates and ease policy further. What the ECB has done is essentially Operation “Reverse Twist.”
Different, but the same
Fed and ECB policy have diverged. But step back and look at the big picture.
We have been told by the ECB that the pace of asset purchases will slow next year. As chief economist Bob Baur recently said, there is a synchronised global upturn in economic conditions currently underway, suggesting that, come 2018, the pace of ECB asset purchases will be reduced further. In the United States, the monetary policy tightening cycle is underway and at least two interest rate hikes are likely next year. Even in Japan, there is a possibility that they will raise the 10-year Japanese government bond yield target next year. Putting this altogether, what does it tell us? Yes, monetary conditions are still very accommodative, but no marginal monetary easing is likely from here. It is, as we say in our 2017 Outlook, the end of the beginning.
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