Euro-zone: The risks of reversal
Despite the ECB’s ultra-cautious approach to reversing monetary expansion, several things could go wrong over the coming year
• The impact of monetary tightening is one of investors’ main concerns for 2019
• The European Central Bank looks set to pursue an extremely gradual exit from quantitative easing
• Even gradualist approaches have risks, including the possibility that the ECB will not have much leeway to deal with a future slowdown
• The prospect of turmoil related to Italy is seen as the risk most likely to materialise
The challenge of reining in quantitative easing (QE) in the euro-zone is one of the greatest uncertainties facing investors over the coming year. Some 53% of institutional investors identified monetary policy tightening as one of the biggest risks to their portfolios in 2019, according to a survey by NN Investment Partners (NNIP).
Many experts seem to take the view that, provided the European Central Bank (ECB) does not make any serious mistakes, the QE reversal should go smoothly. Others warn of potentially serious difficulties ahead including, most clearly but not exclusively, disagreements over the handling of Italy’s debt burden.
Some outcomes look close to certain, while others are open to a considerable degree of uncertainty. Barring any huge surprises, it looks a sure bet that the ECB will take an ultra-cautious approach to unwinding its extraordinary monetary policy. It has signalled its intention to wait for many months before starting to raise rates and longer still before it even considers reducing its balance sheet.
“I find it hard to believe that anybody on the council disagrees that everything needs to be done in the most judicious of all ways possible,” says Jurgen Odenius, managing director at PGIM Fixed Income. “To me that means moving very slowly, very carefully and over a long period of time”.
The attractions of this approach are clear. In recent years, following the turmoil at the start of the decade, the euro-zone has remained financially stable. On that basis, the appeal of keeping things as they are is strong. But what might be called the inertia option is not without risks. For example, some fear that when the next cyclical downturn comes (and there will be one sooner or later), the ECB will not have much ‘ammunition’ left to respond effectively. There will be limited scope to cut rates if they are already at minimal levels, while there are diminishing returns involved in enlarging the balance sheet still further.
Then there are the risks that could knock the euro-zone off course. Opinions differ on its manageability but the row over Italy’s budget could, many maintain, spill over into broader instability. Less widely recognised is the vulnerability of the euro-zone to an external slowdown. Downturns in the US or Asia could hit the euro-zone economy hard.
The year ahead
• December – The ECB is scheduled to end its net new purchases of assets
• January – Change to the ECB ‘capital key’. That is the formula the ECB uses to determine what proportion of bonds it buys from each country. It is updated every five years.
• March – The UK is scheduled to leave the EU
• May – European parliamentary elections
• September – Likely month for first increase in interest rates
• October – End of Mario Draghi’s term as ECB president
• November – The new ECB president takes office
At least the broad outline of the ECB’s winding up of QE is generally accepted. At its meeting towards the end of October the ECB said it would continue to make net asset purchases until the end of this month. Leaving aside a sudden bout of market turmoil it is hard to see this being reversed.
Next is the expected interest rate rise in September, or possibly later in the year. But even if this goes according to plan, it still leaves some questions open. The ECB has several key interest rates including its deposit facility (currently at a negative 0.40%), a fixed rate for its refinancing operations (at zero) and its marginal lending facility (at 0.25%). So the ECB has a range of choices in relation to the particular interest rates it increases and by how much.
Then there are additional elements of the plan which the ECB has announced but their significance has not been not nearly as widely appreciated. The first is that although the ECB will cease making new net purchases of assets, it will reinvest the proceeds from existing bonds when they reach maturity. As a result, the reinvestment programme will cushion the effect of the drop-off in net new purchases. The central bank’s balance sheet will no longer increase but it will stay at about the same level it has reached over the past decade (see figure 1). In other words, the ECB looks set to start raising rates before it begins to reduce the size of its balance sheet.
The reinvestment programme also gives the ECB scope to influence the market through its choice of the duration of the bonds in which it invests. “This is very important because it represents a degree of freedom for the ECB that does not depend on a continuation of QE,” says Guillaume Lasserre, the CIO of Lyxor Asset Management.
He also points out that the ECB looks set to maintain its Targeted Longer-Term Refinancing Operation (TLTRO) – its stimulus programme designed to support the region’s banks – for some time to come. The final tranche of these is not scheduled to mature till the final quarter of 2021. Although this is not technically part of the QE programme, it does, in some respects, run parallel to it. It is another intervention by the central bank to maintain market stability.
It is therefore clear that the ECB will pursue an ultra-conservative approach overall. The central bank seems to be working on the assumption that it is prudent to stay on the course that has helped maintain stability for several years.
The ECB’s approach has its critics. Markus Schomer, the chief economist at PineBridge Investments, argues that central bankers are worried about being held responsible for anything that goes wrong. “Policymakers everywhere fear that if you raise rates and something goes wrong everybody is going to blame you,” he says. In his view this has meant that monetary stimulus is being maintained even when it is no longer necessary. “The problem is we are getting late in the business cycle and we still haven’t started the process of raising rates,” he says.
This relates to the problem that is often referred to as central banks ‘running out of ammunition’. The idea is that they are so fully extended that they are not in a good position to react to the next crisis. To be fair, getting the balance right – between unwinding unconventional policy too early and leaving it too late – is a fraught question for central bankers.
The lack of ammunition may not present an immediate problem for the ECB in 2019 but it could well cause difficulties in the slightly longer term. Although the US economy appears to be doing well in the short term it could slow in 2020. Asian growth could also slow. The question of the likely impact on the euro-zone of Brexit, whatever form it ultimately takes, also still remains open. Given the euro-zone’s high exposure to international trade, the region is particularly vulnerable to external economic slowdowns and recessions (see figure 2).
Although a slowdown in external demand presents a challenge, the most pressing concerns for most observers are internal. Italy is, without doubt, on top of the list. Philippe Waechter, chief economist at Ostrum Asset Management, almost certainly reflects the consensus when he argues that, the prospect of Italy failing “is clearly the main challenge over the coming year”.
Having said that, there are disagreements about the ability of the euro-zone authorities to handle the Italian challenge. Opinions range from relatively sanguine to concerned.
The immediate battle over Italy is fiscal rather than monetary. As is well-known, Italy’s populist government has got into tussle with the European Commission (EC). In an unprecedented move the EC ordered Italy to revise its budget because of the impact that plans to increase spending would have on public debt levels. The Italian government responded by saying it would stick to its budget plan.
In itself, this dispute is a fiscal rather than a monetary matter. The ECB’s remit involves staying out of politics so it will not play a direct role in the row. However, there is a risk that the conflict could spill over – for example, by prompting market volatility, which could then get the central bank involved.
On the positive side, some argue that Italy’s fiscal position is not as weak as generally assumed. Contrary to the common impression, it has a record until now of staying within the euro-zone’s fiscal rules. This is in contrast to others, including France and Germany, whose deficits have breached the euro-zone’s fiscal limits at times. The optimists also point out that although Italy’s public debt levels are high, its total debt, combining public and private debt, is not particularly elevated.
Nevertheless, there are others who broadly share the EC’s concerns about the sustainability of Italy’s debt. The International Monetary Fund’s recent Article IV consultation with Italy agreed that “the planned stimulus carries substantial downside risks as it would leave Italy very vulnerable”. Ostrum’s Waechter argues that there is a risk of a “snowball effect” with Italy’s economic growth levels so low – real levels of output are at about the same level as 2004, according to IMF figures – and relatively high interest rates.
If the problems do manifest themselves, there is still the question of how they could be transmitted to the monetary sphere. Silvia Dall’Angelo, senior economist at Hermes, points out that Italy’s fiscal expansion could itself cause problems in the bond markets. If Italy issues new debt to finance
its stimulus, the central bank’s cessation of new purchases could make it hard. “It could be really tricky for Italy to find buyers for such a large amount when the ECB is no longer there,” she says. This is particularly the case with 2019 looking like a heavy year for redemptions of Italian debt.
While Italy is the main concern facing euro-zone investors over the coming year it is not the only one. Many are worried about the outcome of elections for the European parliament in May. It looks likely that populist parties will do relatively well in the polls.
Pinebridge’s Schomer describes this as “a huge risk event for Europe”. His main concern is not the peripheral European countries but the core. In France the National Rally (Rassemblement National), formerly the National Front, could do well, while, in Germany, the Alternative for Germany (Alternative für Deutschland) could benefit from the disarray in the country’s political centre. “If the French and the Germans play the more nationalistic card, it would not require much to bring back the call in Germany for the return of the Deutsche Mark,” he says.
The final risk facing the euro-zone – at least of those that can be easily predicted – relates to the end of Mario Draghi’s tenure as ECB president in October. It is not that the new president is likely to embark on a dramatically new course of action. However, there is still some uncertainty about who the new president will be and, in the meantime, Draghi’s power could fade as his term nears its end.
Over 2019, the ECB will be hoping to manage a gradual reversal of QE while maintaining what for central bankers is perhaps the ultimate accolade – being boring. If nothing much of note happens in the financial markets in 2019, it will be considered a great success. However, there are enough risks lurking along the way to make such an outcome far from certain.