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ECB enters era of informal yield curve and spread control

The ECB is expanding its pro-growth and pro-inflation asset purchases and allowing the buying programme to run for longer. The objective is to safeguard favourable financial conditions as the eurozone grapples with the economic fallout of the COVID crisis. In effect, the ECB is encouraging investors to search for yield, particularly in those markets for risk assets where the ECB is active.

After the latest meeting of policymakers, the eurozone central bank said the volume of its Pandemic Emergency Purchase Programme would be raised by EUR 500 billion to EUR 1.85 billion and that the PEPP would run for longer, now at least until end March 2022 from the earlier end date of June 2021.

The ECB added a yield and spread curve control (YSCC) objective in the PEPP “to preserve favourable financing conditions over this extended period” and “with a view to preventing a tightening of financing conditions” as the central bank seeks to counter the downward pressure of the pandemic on inflation resulting from weak economic growth.

Growth to contract in Q4

Commenting on economic activity, the ECB said the third quarter was stronger than expected and the prospects for the rollout of vaccines are encouraging. Nevertheless, the pandemic continued to pose serious risks to public health and to economies. The resurgence in cases and the associated containment measures significantly restricted economic activity, which is expected to have contracted in the fourth quarter.

On inflation, the ECB said it remained ‘very low’ in the context of weak demand and significant slack in labour and product markets. Overall, data suggests a more pronounced near-term impact of the pandemic on the economy and long-lasting weakness in inflation than previously envisaged.

Tying a return of inflation to the length of asset purchases

One of its key messages for investors was that the inflation outlook would play a role in determining when the PEPP ends: inflation will need to be back on the pre-pandemic path.

This is open to interpretation. If all that is required is for a future forecast to reach levels from before the pandemic, this could occur in December 2021. If instead actual headline or core inflation has to consistently be at pre-pandemic levels, this may not be seen for a long time.

According to ECB forecasts, core inflation will remain weak, amounting to just 1.2% by 2023, which is far from the ECB’s target. There are real risks to inflation expectations here. Unfortunately, there is not a huge amount that the ECB can do to solve this problem. For the ECB to hit its inflation target, it will need governments to step up with bigger stimulus packages.

A measured approach to asset purchases

The ECB again made it clear that it is not committed to exhausting the full scope of the asset purchase programme: purchases will vary according to what is necessary. In other words, the PEPP envelope will not be used in full if financial conditions remain easy.

This may sound alarming, but it actually isn’t: this is a logical consequence of yield curve control. If you want to set the price of bonds, you must be willing to vary the quantity of bonds that you buy (you can’t set both in advance).

The decision to emphasise that the PEPP envelope might not be used in full likely reflects concerns of hawkish policymakers about overly aggressive asset purchases.

Large-scale asset purchase programmes – also known as quantitative easing (QE) – may be an effective tool to control asset prices, but the ECB now finds itself in the same position as the Bank of Japan has been since September 2016: controlling yields, but relying on good luck or good fiscal policy to achieve its inflation target of below, but close to, 2%.

In effect, the ECB’s approach now has most of the characteristics of yield curve control. While there is no set amount of monthly asset purchases, there is a promise to keep financing costs down. The only thing missing is a formal target.

Long-lasting government bond market support

Yield and spread curve control can be seen as a ‘PEPP put’. In theory, the ECB is obliged to adjust the pattern of purchases according to market conditions: if spreads widen in any systemically important segment, the ECB should increase purchases in that market. In practice, we expect the ECB to be particularly sensitive to a widening in spreads for sovereign bonds.

With the ECB now committing to full reinvestment of its PEPP portfolio at least until the end of 2023, there is long-lasting support for the sovereign bond market. This is designed to encourage eurozone finance ministers to borrow more now and push back the ‘fiscal cliff’.

Euro – not the policy focus for now

On the subject of the euro’s strength this year, we believe the ECB would be very sensitive to any further rapid appreciation or the perception that the euro is on a one-way course. The possibility of deposit rate cuts is not off the agenda entirely, even though it seems clear enough that the ECB would really rather not.

The move to yield curve control, by the way, can be seen to put the policy focus on managing domestic financial conditions (yields and spreads). It potentially puts the burden of dealing with euro strength back onto deposit rate cuts.

Market reaction

Italian, Spanish and Portuguese 10-year bond yields had fallen to their lowest levels on record ahead of the latest policymaker meeting. They rose modestly, but as the ECB broadly delivered measures that were close to market expectations, the reaction was muted.

In recent weeks, the ECB’s bond purchases have driven a record-breaking rally in eurozone debt. On Thursday, Spain issued 10-year debt at a negative yield for the first time, auctioning EUR 920 million of bonds maturing in October 2030 and priced at a yield of minus 0.03%. Spain joins a club of eurozone nations issuing debt for the next decade at negative yields. Portugal’s 10-year yield turned negative in November.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

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