Unravelling the bond market impact of the ECB’s latest policy measures
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.↩