Upbeat comments from European Central Bank (ECB) chief economist Peter Praet indicate that the central bank’s governing council may be nearing a decision about when to pull the plug on the massive, monthly bond buying it has undertaken to stimulate inflation under quantitative easing (QE).
Last Wednesday, Praet told an audience in Berlin that inflation signals were improving. As market expectations of further asset purchases wane, he noted that inflationary expectations have moved in line with the ECB’s 2% target. The economist also pointed to the underlying strength of the eurozone economy. Coupled with higher wages, he anticipates that this could lead to higher inflation.
With the next ECB meeting scheduled for 14 June, some investors view Praet’s comments as an indication that the central bank’s bond-buying programme could come to an end later this year. At the moment, it is scheduled to run until September at least. This is a concern as it is the injection of money into the financial system plus the economic recovery that has propelled European stock markets in the past two years.
Carsten Brzeski, chief economist at ING Germany, added that recent weakness in the euro and higher oil prices should lead to an upward revision of the ECB projections for inflation.
‘Judging from Peter Praet’s comments, it also seems that the majority of the ECB considers the series of weaker hard macro data as a soft patch rather than the start of a downswing of the eurozone recovery,’ he explained.
However, some fund managers question whether the time is right to stop QE at a time when political risk has increased in the eurozone, creating the potential for further market volatility. One of the biggest uncertainties facing the eurozone right now is Italy.
Several failed attempts to form an interim government sparked a market sell-off over the past few weeks, causing 10-year Italian government bond yields to jump above the 3% mark. Fortunately, they retreated below that level after a populist coalition government was agreed, led by law professor Giuseppe Conte (pictured above).
‘Recent events in Italy have served to remind of the dangers of discounting populist politics. Whilst Italy is not leaving the euro any time soon, the notable absence of credit risk priced into Italian assets a mere month ago was foolhardy,’ said Stefan Isaacs, manager of the M&G European Corporate Bond fund.
Isaacs suspects the ECB will take comfort from the limited contagion from the Italian sell-off to other peripheral markets so far. Nevertheless, he suggests that it underscores the dangers of tightening policy at this point in time.
‘Dialling back stimulus in the face of increased market volatility and a tightening of financial conditions in Italy will leave the doves on the ECB Council uneasy,’ he added.
Too much, too soon?
Although Jens Weidmann, Deutsche Bundesbank president, and other notable hawks point to recent German inflation of 2.2% and firming labour markets across the eurozone, Isaacs believes there is a danger of tightening policy too early.
He points to comments made by Arnaud Marés at Citigroup, who is a former special adviser to ECB president Mario Draghi (main picture), who argues that a central bank requires 3-4% of rate cuts to be confident they can stimulate an economy in the face of a significant economic slowdown.
‘The chances of the ECB getting anywhere close to this watermark before the end of this current cycle are practically zero,’ Isaacs said.
‘Given the lack of fiscal firepower available to eurozone governments, the ECB finds itself in an unenviable position. The onus remains on easy monetary policy to support economic growth in the eurozone and the central bank is best served by erring on the side of caution,’ he added.
In spite of the hints, ING’s Brzeski, expects the ECB will not easily give away flexibility and room for manoeuvre on QE.
‘Against this background, clear hints at an end of QE, while keeping full flexibility, at next week’s meeting still seems the most likely outcome.
‘Then, the July meeting could bring the announcement of a QE extension at a lower pace at least until December,’ Brzeski said.
If underlying inflation increased during the second half of the year, the economist estimates that QE could then be stopped in December.
Andrea Iannelli, fixed income investment director at Fidelity International, expects the ECB will progress with plans to taper its bond-buying programme.
‘The ECB has shown little interest to change its stance in the face of higher market volatility and the latest, higher-than-expected eurozone CPI print will give them enough reasons to announce further tapering of QE in the summer.
‘The messaging, however, is likely to remain dovish as political tensions simmer in the background and may resurface. Deposit rates are therefore likely to be unchanged for a long period of time,’ he added.