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ABCs of ECB Tapering Risks

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Before reviewing the European Central Bank (ECB) policy options, let's take a quick look at the current macro picture in Europe:

  • Brexit was expected to trigger a downturn in the U.K. economy as well as the broader European economy, but we haven't seen any immediate tangible consequences
  • While the short-term macro environment in the eurozone is improving, the economic recovery is very slow
  • Inflation is subdued and forecasts remain well below the 2% ECB target

So, on balance, from a macro perspective, there's very little incentive for the ECB to immediately start tapering its quantitative easing (QE) program.

The ECB delivered on market expectations and made no changes to interest rates or the QE program during its October meeting. But, by its December meeting, the ECB will need to provide a few clarifications. In particular, will the QE program, which is currently scheduled to purchase €80 billion of bonds per month until March 2017, be extended? And if, as we expect, it is extended, the ECB will need to explain how it will modify the rules of this program in order to be able to keep buying bonds. Lastly, the market will be looking for signals with respect to the timing and magnitude of the tapering that will eventually come.

From a macro perspective, there's very little incentive for the ECB to immediately start tapering its QE program. But there's market and political pressure to explain its longer-term plan.

While Mario Draghi, president of the ECB, mentioned the possibility of extending the program beyond March 2017, there has been no firm news.

The problem that the ECB is facing is two-fold. If the ECB doesn't remove some of the self-imposed constraints on the bonds it can purchase, it may run out of bonds to buy. However, if the ECB pushes too hard to remove these constraints, it increases political tensions with Germany. After all, these constraints were put in place to avoid the appearance that the ECB is using monetary policy to help finance struggling European governments.

So, while the economic backdrop is not creating any incentive to taper the QE program immediately, the ECB will soon need to explain how and when it will taper its bond-buying program. And uncertainty concerning this exit plan could create increased volatility in the bond market. Indeed, the ECB will need to account for multiple factors in normalizing its unconventional monetary policy:

  • Nonhomogeneous economies across the eurozone
  • Banking industry suffering from a flat term structure and negative interest rates
  • Political pushback from several countries, most notably Germany
  • Constitutional questions raised by the German Federal Constitutional Court
  • Bond-buying constraints that are creating scarcity of available bonds to purchase

Investment Implications

We are closely monitoring these factors as we remain long of fundamentally attractive European equities and we recently initiated a long position specifically on European financials. Why? First, from a valuation perspective, European financials are extremely attractive.

Second, in order to implement its monetary policy, the ECB needs European banks. It cannot extend credit to the wider European economy without healthy banks.

As I mentioned above, banks have been suffering from the nontraditional policies implemented by the ECB. Negative interest rates were a problem for European banks, as they were unwilling or unable to impose negative rates on their depositors. And banks, which typically benefit from an upward sloping term structure, are experiencing a flat term structure as a result of the ECB buying bonds on the longer end of the curve.

But, given the ECB needs the banks in order to conduct its monetary policy, we believe it will help restore bank profitability. That's why in regulatory discussions, for example, key ECB officials have repeatedly stated that, for the banking sector as a whole, capital requirements will not increase.