March ECB meeting preview: The battle over bonds
By Jeremy Hawkins, Senior European Economist
March 9, 2021
Updated quarterly economic forecasts could potentially provide the ECB with the fundamental ammunition it might need to justify another relaxation of policy this week. However, any adjustment to its stance at Thursday’s announcement is unlikely to reflect a significant shift in the central bank’s assessment of where the Eurozone economy is headed. By and large, comments from Governing Council members have suggested that recent economic developments have been, at least broadly, in line with the central case projections presented in December. As a result, the market consensus favours no change in QE while continuing to rule out any further cut in official interest rates. However, there is still some speculation that the central bank might feel obliged to act in order to keep the region’s longer-term borrowing costs under control.
For more than two years Eurozone inflation has undershot the ECB’s near-2 percent medium-term target, raising doubts about the credibility of the target itself and, ultimately, questioning the determination of the central bank to meet its price stability goals. So, it would seem perfectly reasonable to assume that the monetary authority would be more than a little relieved about what has been a sharp increase in the yearly HICP rate so far in 2021. However, rather than welcoming the acceleration, Governing Council members have expressed major reservations about the possible impact of higher inflation on longer-term sovereign bond yields. These yields are used by banks as a reference point when setting the price of their loans to households and firms and, with the Eurozone economy currently contracting, the ECB is desperate to avoid anything that interferes with the lending flow. As it is, private sector credit growth has already shown signs of slowing.
The central bank’s Chief Economist Philip Lane reiterated late last month that the ECB is not engaged in yield curve control in the sense that it wants to keep a particular yield constant. Rather, he maintained that QE “seeks to move the curve in a certain direction and with enough force to support inflation dynamics.” While exactly what this means is unclear, recent weeks have seen a concerted effort by Executive Board members (including President Lagarde) to talk Eurozone yields back down again. Consequently, with 10-year yields still historically very low and the yield curve negative out to 17 years, the underlying policy message would appear to be that the ECB is far from convinced that an economic recovery in the second half of the year is a done deal.
Crucial to the monetary stance is the ECB’s assessment of financial conditions. As highlighted in its January policy statement, the central bank is determined to “maintain favourable financing conditions”. The central bank is currently calculating just how this might be measured but it is apparent that yield levels and spreads are particularly important. To this end, despite the increase in nominal yields, real yields have fallen following January’s spike in inflation and spreads have not widened. Indeed, at the time of writing, the gap between 10-year Italian BTPs and German bunds is just 102 basis points, down from 130 basis points at the start of the year.
Nonetheless, the ECB is clearly worried and must be aware that jawboning financial markets without taking any concrete action is only ever likely to work as a stopgap measure. As such, it might want to underpin its verbal intervention by accelerating the pace of its asset purchases and the easiest route to do that would be via the pandemic emergency purchase programme (PEPP). Monthly purchases have remained well short of the €120 billion peak seen in June last year and as of end-February, only €870 billion of the €1.85 trillion fund had been utilised. The PEPP is flexible with no fixed monthly purchase rate so buying could be easily stepped up without having to add to the overall programme while leaving the more rigid asset purchase programme (APP) unchanged at €20 billion/month.
The Eurozone economy actually performed rather better than generally expected at the end of 2020 but real GDP growth was still negative. Moreover, the latest round of virus restrictions has significantly increased the likelihood of another fall in total output this quarter which would make for a second double-dip recession. Consumption has been hit especially hard – retail sales volumes slumped nearly 6 percent on the month in January and, despite a still relatively buoyant manufacturing sector, PMI surveys show widespread recession in services.
News on the coronavirus since the last meeting has been mixed. Infections rates were generally moving up in January but tighter restrictions led to a sizeable fall over most of February. However, in a number of countries the decline has flattened out and in several, new cases have started to rise again. This has led to the extension of some national lockdowns – notably in Germany which now looks likely to last until at least 28 March.
Not helping matters is the persistently slow pace of the Eurozone’s vaccine rollout which lags well behind the likes of the UK and U.S. Indeed, in early March, the vaccination rate for the four largest member states was only about one quarter of the pace seen in the UK. Having now secured extra doses from Pfizer and Moderna, the EU Commission is aiming to inoculate around three quarters of the entire EU population by the end of August but this timetable could still prove too optimistic. Rising virus mutations have increased transmissibility and, recognising the implied threat to economic recovery, the ECB has called for the delivery to be speeded up.
In summary, the ECB finds itself in the awkward position of wanting higher inflation but not the increase in longer-term borrowing costs that this would normally be expected to bring. With debt issuers venturing further along the curve in 2021, any additional rise in inflation would probably make controlling the long end of the yield curve impossible without an outright increase in the central bank’s bond demand. Even then, there would be a risk that the ECB might be seen to be falling behind the curve which could give an extra boost to yields. In fact, it could well be that the battle over bonds has only just begun.