ANALYSIS-Bond markets look beyond easy ECB money to first rate rise
The timing of a European Central Bank rate rise is fast taking over as the main driver of borrowing costs in the euro area as investors begin to sense that the bank’s massive stimulus scheme may end sooner rather than later.
When the ECB said it would halve monthly bond purchases to 30 billion euros ($36 billion) from Jan. 1 but keep the scheme until Sept. 30, there was an expectation its asset buying would only be wound down gradually thereafter over a period of months.
Given the ECB has said rates would remain unchanged until “well past” the programme had ended once and for all, many investors assumed interest rates would stay on hold at least until late 2019.
But in the past two weeks, some ECB officials have suggested the 2.55 trillion euro asset-purchase programme could end altogether in September – potentially bringing forward the timing of the bank’s first rate rise since 2011.
According to money market pricing, investors have brought forward expectations of an increase by about six months to early 2019, suggesting a rate rise could come well before Mario Draghi’s term as ECB chief ends in October next year.
Yields on short-dated bonds, the most sensitive to changes in interest rates, have also started to move higher, indicating that expectations of tighter monetary policy are starting to outweigh the impact of so-called quantitative easing (QE).
Five-year bond yields in Germany, the euro zone’s biggest economy, rose 10 basis points in December, the biggest monthly jump in six. Two-year German bond yields are near five-month highs at minus 0.62 percent while 10-year bond yields hit two-month highs last week.
“Right now long-term rates are determined by the timing of a first rate hike rather than the flow of QE,” said Peter Chatwell, head of rates strategy at Mizuho in London.
ANTICIPATING THE END
At the start of December, euro zone government bond yields were near multi-month lows, even though some asset managers said they should be higher given the reduction in bond buying to come and the risk of tighter monetary policy.
Analysts say the market shift came after comments from the ECB’s Benoit Coeure and Ewald Nowotny. Coeure, the man in charge of the bank’s asset-buying programme, said on Dec. 30 there was a reasonable chance it would not be extended.
Nowotny said in an interview published on Jan. 2 that QE could end in 2018 if the euro zone economy continues to grow strongly and on Sunday, the Bundesbank’s Jens Weidmann said the ECB should set a date to end QE.
The ECB’s “forward guidance” on rates staying low for the foreseeable future has been credited with capping medium-term borrowing costs for governments and firms alike and is one policy tool the bank can use after QE ends.
But that guidance, and its ability to anchor borrowing costs, could be put to the test if the euro zone economy continues its strong expansion, inflation creeps up and markets sense a rate rise may be coming sooner rather than later.
Central bankers know that preparing the ground for a withdrawal of stimulus is crucial. In May 2013, then-Fed chair Ben Bernanke sent global bond markets into a tailspin by suggesting the U.S. central bank’s bond buying could be reduced – an event known as the “taper tantrum”.
“Rate hikes are not a 2018 story but even the mention of that means that markets are very unprepared,” said Timothy Graf, head of macro strategy for EMEA at State Street Global Markets.
“Markets are going to be increasingly watching any signs of when rates may rise beyond the tapering news flow which has broadly been factored in,” he said.
Money market prices suggests investors have in recent weeks bought forward their expectations for the first rate rise by about six months, closer to March 2019.
The difference between the overnight bank-to-bank interest rate for the euro zone (Eonia) and forward Eonia rates is about 5 to 6 basis points in 18 months’ time.
Analysts say that means investors are pricing in a 50-60 percent chance of a 10 bps increase in the ECB’s deposit rate – the minimum it is likely to increase – from minus 0.4 percent.
ING senior bond analyst Martin van Vliet said the earliest occasion for the ECB to provide some clarity on the outlook for interest would be June, given it only announced the reduction to its QE programme in October.
“It is definitely going to be a year where the QE premium is priced out,” he said.
The switch in focus to the timing of an ECB rate rise also means inflation data could have a greater impact on markets than in recent years, analysts said.
Inflation in the euro zone remains stubbornly low at 1.4 percent – or just 1.1 percent when volatile food and energy prices are stripped out – well below the ECB’s target of an inflation rate of nearly 2 percent.
Yet purchasing managers surveys showed that the euro zone economy ended 2017 with its strongest growth in seven years, driven by accelerating services and manufacturing activity across all major economies.
“This year will be all about core inflation, core inflation, core inflation,” said Frederik Ducrozet, senior economist at Pictet Wealth Management in Geneva. ($1 = 0.8356 euros)
(Reporting by Dhara Ranasinghe; additional reporting by Saikat Chatterjee; editing by David Clarke)