Unravelling the bond market impact of the ECB’s latest policy measures
The bond market’s response to the European Central Bank’s (ECB) latest easing measures was immediate and broadly positive, but the implications for the real economy are harder to gauge.
16 March 2016
The market’s immediate reaction to the latest easing measures announced by the ECB on 10 March was, in some respects, counter-intuitive.
Most investors will be used to seeing government bond yields fall in the wake of greater-than-expected policy easing, but in this instance, 5-year and 10-year Bund yields rose steeply.
This is because Bund yields had already been driven to extremely low levels during January and February’s firmly ‘risk-off’ market tone.
The ECB’s latest support measures cheered markets, and resulted in some of the ‘safety premium’ embedded in Bund valuations being reduced.
A boost for bond bulls
Indeed, there is little doubt that the latest steps from ECB President Mario Draghi are positive for financial markets.
The first phase of ECB asset purchases, in early 2015, focused on buying government debt. This pushed government bond prices up and nudged investors into riskier assets to replace the lost yield.
The fact that risk assets – currently non-banking investment grade corporate bonds - are now included in the expanded €80 billion-a-month asset purchase scheme, means that the ECB is driving down the cost of risk more directly.
This impact has also been positive for equity markets, because the cost of capital has improved.
Will the changes make a "real" difference?
The implications for the real economy are less clear-cut.
A high proportion of the liquidity which should have entered the US economy through its own quantitative easing (QE) schemes became ensnared in the banking system, and the velocity3 of money didn’t appreciably pick up.
There was no real spike in lending, and regulatory changes meant that the mortgage market remained somewhat impaired.
Of course, if QE had never been implemented, then the condition of the US economy could have been far worse.
In our view, the likelihood of the ECB achieving its vaunted 2% inflation target, even within five years, is low.
The output gap4, which bears down on both worker and company pricing power, is too significant for prices to improve to the 2% target growth rate.
Economic growth – currently forecast to be around 1.4% in 2016 – is insufficient to close this output gap quickly. The ECB, in our view, will need to do more.
The waiting game
This, then, begs the question of why Mario Draghi followed up the latest policy announcements with the suggestion that further rate cuts are “unlikely”.
The euro, having fallen after the deposit rate was reduced, rose as soon as Mr Draghi made the comment. However, we see his observation as largely practical.
Running a negative interest rate policy is unlikely to work in the long term, as it would encourage investors to hoard cash.
Excessively negative rates mean that even the cost of insuring cash deposits ‘in-house’ could be less significant than the cost of depositing funds with the ECB.
However the ECB proceeds from here, it seems unlikely that the deposit rate will be the tool that they reach for.
For now, we believe that the amended policy environment has bolstered existing support for risk-asset markets and settled simmering nerves.
Patience will be required to see quite how effective the measures will be for stimulating more economic growth.
1. Investment grade bonds are the highest quality bonds as assessed by a credit ratings agency. To be deemed investment grade, a bond must have a credit rating of at least BBB (Standard& Poor's) or Baa3 (Moody's).↩
2. Yield spread is the difference in yield between different types of bonds. Credit spread is the difference between corporate bonds and government bonds.↩
3. Velocity of money represents the number of times a particular unit of money is spent over a period of time, or how quickly money changes hands. A country's GDP is the total amount of money available and its velocity.↩
4. The output gap refers to the difference between an economy’s current output and maximum potential output. An economy with no output gap is operating at full capacity.↩
Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.