ECB Bond Change Pulls the Rug from the Long End
(Bloomberg Opinion) -- It certainly appears dovish that the European Central Bank expects to reinvest even more of its maturing holdings next year, as Bloomberg News reported Wednesday. It’s even more so if, as President Mario Draghi has suggested, officials relax the rules on how much time they can take to make reinvestments – more flexibility here gives them room to smooth ructions in the bond market.
But there’s something for the hawks as well. The net result could be to drive short-end yields for core European country bonds further into negative territory, and in the process steepen the yield curve.
The reinvestments could range from 160 billion euros ($184.6 billion) to 200 billion euros next year – that’s up from the bank’s previous expectation for about 150 billion euros. It's a bit odd that the ECB offers such a wide range – surely it knows what it owns, and therefore what is due to roll off. But once you realize that it doesn’t know what it will buy from now until the end of QE in December, the uncertainty makes sense. That doesn’t mean its future purchases are a total mystery.
It’s reasonable to think that ECB purchases between now and the end of the year will be heavily weighted toward the short end of the curve. The central banks of core countries, who actually buy the securities, have long been keen to reduce the duration of their holdings, but there’s added urgency now that purchases are ending. Bundesbank President Jens Weidmann’s remark on Thursday, that ending QE was the first step of a multi-year normalization, fits nicely with ever-shorter bond holdings – they pave the way for a swifter exit from the program.
This approach also has the consequence of boosting the amount of maturing debt next year. This manages to give Draghi a decent war chest and an ability to intervene to calm bond market volatility, which is worth noting given that the flow of purchases will have stopped. A little something for everyone, then.
There are two consequences to this shift. First, the stimulus of the remaining flow of new purchases will be sharply curtailed. Buying a one-year bond instead of a 10- or 30-year security has less of an impact on the broader market.
That could mean a lot less support for longer-end core yields – and potentially less support for peripheral bonds relative to Germany at that end. This partly depends on whether the ECB also changes rules on reinvesting the maturing debt of one country (say, Germany) into the bonds of another (say, Italy). But that’s a question for another day.
With the flow of new QE ending this year, the next battleground on the Governing Council is how long the stock of QE is kept static. And when the ECB does take a step to paring this, most likely by first refusing to reinvest maturing securities, the impact will be felt much sooner the lower the duration of its holdings.
If Draghi can raise the flexibility of when reinvestments are made, this may smooth the path to shrinking the central bank’s balance sheet. This approach to tweaking reinvestments looks set to keep yields at the short end firmly negative, and to remove one prop to the longer end. But if all goes to plan, the Draghi put will remain alive and well – and when he leaves the bank next year, he’ll have given his replacement the tools to avoid a taper tantrum. His legacy would be intact.
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