The limits of “no limits”

The European Central Bank (ECB) is running into self-imposed limits on its asset purchases. An improving growth outlook and the fading of deflationary fears are also fueling market expectations for an ECB policy adjustment. The ECB’s next policy meeting in October will come just as the Federal Reserve begins a well-telegraphed plan to start an outright slimming down of its balance sheet.

Yields bottom out

Treasury yields have bounced higher again in September after a two-month slide. The overall tone this year remains risk-on, with emerging market debt and credit leading year-to-date performance in the fixed income world, as seen in the table below.

An evolving outlook

The prospects of both the U.S. winding down its balance sheet and the ECB contemplating the next iteration of its monetary accommodation put central banks in the spotlight –less bond buying by the ECB and outright balance sheet reduction plus further rate rises ahead from the Fed.
This heralds the end of crisis-era monetary policies that kept financial conditions loose and buoyed risk assets. The reversal has implications for global bond markets and financial markets more broadly. Rising rates could, over time, help restore the attractiveness of lower-risk government and shorter-duration debt –at the expense of more richly valued credit sectors that have benefited from the hunt for yield in recent years.
A recovery in eurozonegrowth –and a rise in inflation that is tentative, but has for now at least quashed deflation fears –have been part of the story fueling market expectations for a near-term ECB policy adjustment. The main driver, however, is a perception that the central bank is running up against self-imposed limits in its asset-purchase program.
The central bank’s balance sheet has more than doubled in size since the launch of its public sector purchase program (PSPP) in 2015. See the Before the fall chart below. The central bank added corporate bond purchases in 2016 –before scaling back its total asset purchases to €60 billion per month in April.

Pushing the limits

Inflation is the fly in the ointment. Our recently launched Inflation GPS, which incorporates big data on price trends and daily updates of traditional inflation-related statistics, suggests official data may be modestly understating true inflation in the eurozone. See the Room for catch-up chart above. Nonetheless, the gauge remains well below the ECB’s target given significant remaining slack in the eurozoneeconomy. This suggests any ECB policy change could be more modest and more gradual than what markets are anticipating.
ECB head Mario Draghi has laid out several conditions necessary to reach the central bank’s medium-term price stability target. The rise in inflation must be durable (rather than transient), self-sustained (stable even without monetary policy support) and broad (across the whole of the eurozone). The durable and self-sustaining aspects are the most uncertain. The central bank revised down its inflation projection in September based on the appreciation of the euro, which has risen 6.5% on a trade-weighted basis this year as of mid-September. Any further gains in the euro would complicate the ECB’s task.
Strong growth momentum, faith in a further tightening of the labor market and dissipating fears of deflation support a somewhat less accommodative monetary policy in the eurozone. Yet there are other factors affecting the central bank’s policy stance. The market is increasingly focused on the natural limits to large-scale QE –despite Draghi in 2015 professing no limits to “how far we are willing to deploy our instruments.” But the instruments have their limits: Eurozone central bankers are simply running out of bonds to buy. We discuss these limitations on the following page, as well as how the central bank may go about addressing them.

Running on empty

Unlike the central banks of the U.S. and Japan, the ECB faces the critical question of which countries’ debt to purchase. The central bank aims to reduce ambiguity by purchasing bonds in line with the “capital key” –the percentage of ECB bank capital that each member state contributes based on its GDP and population share in the European Union. Yet there are complications: The amount of debt available for purchase depends on the fiscal stance of each country. For example, France and Italy run relatively high debt levels and deficits, leaving ample debt for purchase. By contrast, lower debt levels in fiscally conservative Germany mean there is a scarcity of debt available relative to the ECB’s target.
The ECB imposes additional limits to mitigate the risk of becoming the dominant creditor of a eurozonegovernment. The current limit prevents it from holding more than one-third of the outstanding paper of any issuer or individual bond. Germany is closest to this limit, as seen in the Nearing limits chart below. Our calculations suggest the ECB could breach the limit for Germany as soon as February. Estimates vary depending on the assumptions, but it is clear the current pace of buying German bonds is unsustainable without a change in ECB rules. A key point: These constraints imply a need for the ECB to tweak its QE program regardlessof its underlying monetary policy stance.
What options does the central bank have? 1) Buy more supranational debt and credit; 2) buy maturities of less than one year; 3) break the capital key (either officially or unofficially); and 4) increase the ECB’s issuer and individual bond (ISIN) limits to as high as 50%. But the simplest way for the ECB to alleviate scarcity issues would be to slow its pace of purchases. This would be made easier if monetary policy goals were in alignment: namely, the central bank expected to meet its inflation objectives over the medium term with less monetary accommodation.

Exit costs

Markets are expecting the ECB in October to signal a step-down from the current €60 billion per month in purchases. The key questions: How will the central bank communicate its policy shift, what will the pace of its step-down be, and what is the endpoint of the ECB’s policy? There is much uncertainty about the mix: A stepdown in purchases could be twinned with an extension of the program’s length, for example.
The looming policy shift has global implications. Low or negative rates have pushed investors out the risk spectrum, narrowing spreads on credit across global markets. And direct purchases of corporate bonds have provided a further support for European credit markets. See the Little premium chart. Tightening financial conditions could also undermine future efforts at fiscal consolidation in the eurozone–and limit the scope of fiscal policy. The compression in sovereign bond yields has helped improve fiscal balances in recent years. But outside of countries participating in bailout programs (think Greece or Portugal), few have made progress on reducing their structural budget deficits –and now face a rise in debt-servicing costs as rates rise.

Bottom line: We maintain a defensive stance on European debt. Tight credit spreads and low sovereign yields highlight limited absolute value in credit, we believe. The still small, but growing, spillover risks to Sweden and Eastern Europe keep our positions defensive in those regions as well. One exception to our defensive stance is eurozonesubordinated financial debt, where banking reforms and capital improvements bolster the investment case, in our view. For core European bonds, we see the risks as tilted toward higher rates. Yet we highlight the potential for negative surprises to risk assets, which argues for keeping some core allocation for diversification.

Jeffrey Rosenberg – Chief Fixed Income Strategist – BlackRock Investment Institute
Joe Di Censo – Portfolio Manager, Global Fixed Income Group – BlackRock
Michael Krautzberger – Head of Pan-European Fixed Income Team – BlackRock