The euro sign sculpture stands illuminated near the former European Central Bank (ECB) headquarters at dusk in Frankfurt, Germany (Photographer: Krisztian Bocsi/Bloomberg)

The ECB Faces a Balance Sheet Dilemma

(Bloomberg View) -- Nature versus nurture. That philosophical debate is more pertinent than ever when it comes to the interventionist efforts of central banks that seek to will their economies back onto a sustainable growth path. But even the noblest of intentions can bump up against limitations when nature, in this case the free functioning of financial markets, is hampered to a great degree.

Such is the dilemma facing European Central Bank President Mario Draghi as preparations begin for the day next month when the institution starts reducing the amount of money its pumps into the financial system. The ECB said in December that it will start reducing monthly bond purchases in April, from 80 billion euros a month ($86 billion) to 60 billion euros.

According to most respondents in a Bloomberg survey, the ECB is unlikely to announce a further reduction in the pace of quantitative easing measures until its September meeting. Even so, an ultimate end to QE, to say nothing of interest-rate increases, could easily require all of 2018 and even stretch into 2019.

To take but one example of how investors stand to benefit, the ECB now owns more than 10 percent of the European corporate bond market. Even after reducing purchases, the central bank will continue to have a big presence in the market. The irony is that mechanics forced Draghi into corporate debt after the ECB’s sovereign-bond purchases pushed yields of those securities too far into negative territory, triggering market dislocations.

The ECB Faces a Balance Sheet Dilemma

Former Federal Reserve Chairman Ben Bernanke faced similar challenges four years ago, as the central bank’s $85 billion-per-month QE campaign was approaching its own exhaustion point. By July of 2013, five months before the taper was announced, the Fed owned at least 40 percent of the stock of Treasuries with maturities of five years or greater. 

The situation in the market for U.S. mortgage-backed securities was even more pronounced. The dollar amounts purchased in the MBS market had the Fed on pace to buy 70 percent of new issuance by year-end 2013. Setting aside the perceived benefits to homebuyers in the form of suppressed mortgage rates, the Fed was at risk of crowding out natural buyers in the market. The mechanics of QE presented challenges of its own.

Whether the term “taper” is assigned to the reduced pace of ECB purchases is a matter of semantics. More importantly to investors, a reduction doesn’t begin to imply the ECB is ready to shrink the size of its balance sheet, a much more dramatic step in the tightening process the Fed has yet to take even though it has started to raise interest rates.

The ECB Faces a Balance Sheet Dilemma

As things stand, the Fed’s continued reinvestment program to maintain the size of its $4.2 trillion balance sheet requires it remain a significant buyer in both the Treasury and MBS markets. The same will be the case with the ECB.

As inflation accelerates toward central bankers’ targets in the U.S. and Europe, and even begins to show signs of life in Japan, perhaps what investors should be more closely focused on is the sum of tightening financial conditions building in the pipeline.

“How much monetary tightening will we see this year in the aggregate when we total what the Fed, the ECB, the Bank of England and the Bank of Japan will do?” Lindsey Group Chief Market Analyst Peter Boockvar asked in a recent note to clients. “What we do know is we have seen peak monetary largesse that is now reversing. All else is noise.”

Punctuating that point, Boockvar went on to warn, “Mario Draghi and the epic bond bubble he has created remain the biggest threat to the region.” Given how interconnected we’ve learned markets to be, combined with the Fed’s assuming an aggressive stance, it’s fair to say the threat extends well beyond any one “region.”

With valuations stretched, euphoria is at its own extreme and complacency as conspicuous as it’s ever been. History dictates that death can come on suddenly if central bank maneuvers take markets by surprise. That’s especially true in controlled environments engineered by overly ambitious central bankers, in financial markets that have been nurtured beyond what nature ever intended.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, is the author of "Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America," and founder of Money Strong LLC.

To contact the author of this story: Danielle DiMartino Booth at Danielle@dimartinobooth.com.

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