Is quantitative tightening really happening in the euro zone?

Hannelore Foerster

By

Carsten Brzeski, Global Head of Macro

Antoine Bouvet, Senior Interest Rate Strategist


The European Central Bank seems determined to follow in the footsteps of the Federal Reserve. After the start of aggressive rate hikes, and with no end yet in sight, the next step is a reduction in its bond portfolio. However, we believe the ECB’s hawkish policy may be premature. Quantitative tightening will come, but not now.


QT is on the ECB’s radar but remains a distant prospect

Minutes from the ECB’s September meeting yielded some interesting tidbits: the decision to raise rates by 75bp was not unanimous, so 75bp increases shouldn’t be the news standard. However, the ECB was clearly determined to continue the significant rate hike.

Furthermore, beyond the configuration of the key ECB interest rates, the minutes underlined that the large balance sheet of the Eurosystem continued to offer an important easing of monetary policy by compressing the term premiums . The Governing Council felt it appropriate to recall that it was ready to adjust all the instruments falling within its mandate to ensure that inflation returned to its medium-term objective of 2%. This is a clear signal that the reduction in the ECB’s balance sheet has become a problem.

Quantitative tightening (QT) – how to reduce the size of the balance sheet – was also apparently on the agenda of this week’s non-monetary policy meeting in Cyprus. However, so far, no information has been released about this meeting.

Bond yields have already risen markedly in recent months without any quantitative tightening

A discussion is one thing, a concrete decision is another. Just over a week ago, ECB President Christine Lagarde said that the ECB would only start considering QT when the ECB had completed the normalization of its monetary policy. At the same time, bond yields have already risen significantly in recent months without any QTs. Additionally, given the highly uncertain economic outlook and increased pressure on governments to deliver additional fiscal stimulus, QT at the current juncture could trigger an unwarranted widening of bond spreads, i.e. that is, a new euro crisis.

This is something the ECB clearly does not want. A premature QT decision also carries other risks. This could raise the bar even higher for the triggering of the Transmission Protection Instrument (TPI), a development that could actually trigger another Euro crisis. As such, an actual move on QT is highly unlikely as it would add financial stress and uncertainty. However, it’s good to at least have a plan for when it’s really needed.

How the ECB’s QT could work

Although quantitative tightening currently seems unlikely, it will eventually happen. Given the complicated structure of the ECB’s bond purchases across countries, sectors and durations, an outright sale of the bond portfolio will not be easy without disrupting markets.

Remember also that the ECB’s balance sheet includes not only the bond portfolio, but also the series of liquidity operations intended to support bank lending. These bank loan operations (TLTRO) will be repaid by the banks, automatically reducing the balance sheet. Yet when financial markets think of QT, they think of canceling ECB asset purchases. In this respect, the option of gradually and more passively reducing its asset portfolio seems the most attractive.

The option of gradually and more passively reducing one’s portfolio of assets seems the most attractive

A possible first step would be to stop (gradually) the reinvestments of the asset purchase program (APP). One way to phase in QT would be to first cap APP reinvestments at 50% of their normal amount during, say, the second and third quarters before ending them in the fourth.

In this scenario, the resulting balance sheet reduction would be a manageable €155 billion in 2023, doubling to €300 billion in 2024. The next step would be to end reinvestments under the program Pandemic Emergency Purchase Plan (PEPP). These would be on top of the balance sheet reduction in 2025, resulting in a total reduction of €388 billion (including APP reductions). In addition, the ECB could accelerate the process with outright selling, but we doubt that peripheral bond markets will be able to withstand the impact (see the following sections).

In terms of timing, we take Christine Lagarde’s recent comments for granted and expect a gradual end to APP reinvestments between the 2nd and 4th quarters of next year. PEPP reinvestments will cease by the end of 2024.

QT could reduce the ECB’s balance sheet by €155bn in 2023 and €300bn in 2024

Source: Refinitiv, ING
Source: Refinitiv, ING

Whenever this happens, we expect QT to play out in three dimensions of the rates markets: duration, credit (and sovereign) premia, and money markets (via the price of liquidity).

Impact on core returns: moderate at the start

One of the channels through which QE has influenced the markets has been the removal of the offsetting of a number of risks, including duration risk.

On the face of it, this means that when the ECB shrinks its balance sheet, long-term yields will rise. So far, so good. There is empirical evidence for this. For reference, we find that a €155 billion reduction in the size of the ECB’s bond portfolio in 2023 would only raise 10-year Bund yields by 7 basis points, and that a reduction of 300 billion euros in 2024 would reduce them by 14 basis points.

If that doesn’t sound impressive, note that without the ECB’s €5 billion purchase, 10-year Bund yields would be 230 basis points higher by this admittedly rough estimate. Also note that QT would increase the amount of debt that private markets would have to absorb if European governments dramatically increased their borrowing to fund energy support programs. This is another argument in favor of a delayed QT start.

A €155 billion reduction in the size of the ECB’s bond portfolio in 2023 would push 10-year Bund yields up by just 7 basis points

What is much harder to track is the impact this will have on the shape of the yield curve. On paper, the longer the maturity point, the more QE suppresses returns. However, we do not expect any further emphasis due to the QT. The US and UK experience has shown that yield curves can invert even in the context of QT. The reason for this is that other factors have a greater influence, namely that base rates exceed their long-term neutral levels. In short, we are still expecting an inversion of the German curve next year whatever the QT.

Without QE, 10-year German Bund yields would be more than 200 basis points higher

Source: Refinitiv, ING
Source: Refinitiv, ING

Sovereign spreads: adding fuel to the fire

Moving away from so-called “risk-free” markets, the main impact of QE is the removal of credit netting. In the case of sovereign bonds, QE was instrumental in removing the risk of a eurozone break-up during the sovereign crisis of 2010-12 and subsequent periods of market stress.

Our analysis of German returns above implies that stock, rather than buying flow, is the relevant variable for assessing market impact. It’s not so simple for sovereign spreads, where both variables matter. Clearly, we believe that the impact of QT on sovereign spreads will occur much faster than on base yields, once flows turn negative. This explains why spreads have already started to widen even before QT was discussed, as QE buying was coming to an end in mid-2022. We fear that the ECB continuing with QT would add to the concerns of already stressed financial markets.

We struggle to see how peripheral markets would cope with rising interest rates and QT at the same time

We struggle to see how peripheral markets would cope with rising interest rates and QT at the same time. This is one of the main reasons why we expect QT to start only after the phase of rising base interest rates is over. In addition, the fact that the ECB keeps spread support programs, such as the TPI, at hand would go some way to reassuring the markets. It would also mean a slower reduction in the ECB’s bond portfolio if it is forced to temporarily buy peripheral bonds.

QT will reduce excess liquidity and help widen money market spreads, such as Euribor

Source: Refinitiv, ING
Source: Refinitiv, ING

Money markets: removing the comfort blanket

A large part of money market rates also has a credit and duration component, which we have discussed in the sections above. But compensation in the money markets is even more strongly suppressed by the wave of excess liquidity (EL) from the ECB introduced during the successive rounds of QE and loans to banks (TLTRO). At the start of QT, EL will decrease by the same amount. In 2023, the estimated €155 billion reduction in QT’s excess liquidity will pale in comparison to the almost €2 billion reduction from loan repayments from targeted longer-term refinancing operations ( TLTRO).

Each gradual reduction in liquidity will make money market rates more sensitive to other risk factors

After that date, however, each gradual reduction in liquidity will make money market rates more sensitive to other risk factors. The widening of money market spreads, for example Euribor fixings versus overnight index swaps (OIS), is not linear. The first reduction of 2 billion euros will probably have little effect. After that, at the latest after mid-2023, the impact of the EL reduction will accelerate. This effect could even be amplified if the ECB decides to effectively lock in part of EL using staggered bank reserve remuneration (see our article on this subject).


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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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