17 June 2015

Financial Times/Heise: ECB must resist call to smooth bond moves

Michael Heise is chief economist of Allianz SE

Is the bond market tantrum over? This is not a good time to make predictions about financial markets. Volatility is such that trends can turn almost overnight. The recent tantrum illustrates this clearly.

Many observers, myself included, had predicted that volatility in the bond markets would increase. In the event, we were taken aback by the speed and intensity with which the market corrected.

Until May, investors had expected that the European Central Bank’s bond buying programme would push the yields of German Bunds to zero or even below. Deep down, everyone knew such low rates were an aberration, given prevailing economic conditions. But everyone clung to the belief that the ECB would keep rates low and falling.

When new data releases showed that inflation as well as inflation expectations were recovering, that GDP growth was stabilising and monetary conditions were returning to normal, the bond market turned. Some investors, caught on the wrong foot, were forced to clear their positions and sell into a falling market. So where do we go from here?

Using the level of US bond yields and money market rates (which are currently close to zero), we calculate that the equilibrium value of German 10-year sovereign yields would be around 1.5 per cent at the moment.

Rates have been much lower in practice because of targeted liquidity operations and the ECB’s quantitative easing programme. If we assume that the ECB continues its QE programme over the next few quarters, current 10-year Bund yields, at slightly below 1 per cent, already look fairly high. From that perspective, most of the bond crash should be behind us.

It is not that straightforward, however. Recent data show that inflation expectations are on the rise. The five-year forward inflation swap rate, which the ECB follows closely, has reached 1.8 per cent. In as much as the rise is caused by the oil price recovery, it should not be a matter of concern.

However, rising inflation expectations could also be the result of the ECB’s expansionary monetary policies. In a sense, that would be a measure of success. But it also creates complications for monetary policy. Since Irving Fisher quantified the relationship in 1930, we know that inflation expectations determine long-term bond yields. When inflation expectations rise, the ECB loses control of long-term bond yields. That would certainly restrict the central bank’s capability to counter rising bond yields in a bond market tantrum.

A buying spree for government bonds might not keep rates down, but rather push up inflation expectations over time. That would be counterproductive. The ECB itself has argued that using QE to blow up its balance sheet would fuel inflation expectations.

The ECB would be well advised to resist the calls for discretionary action to smooth out bond yields (which does not rule out some seasonality in its purchase programme). It should communicate clearly that the QE programme will continue until inflation indicators move back towards the reference value of below but close to 2 per cent. If improving economic conditions lead to higher inflation than the ECB currently expects, it should start tapering. If price rises lag behind expectations, it should extend its programme as needed.

To enhance transparency, it should adopt a discernible rule on which to base its bond purchases. This could include several of the inflation indicators the ECB deems relevant for its policy decisions.

The recent bond market tantrum has illustrated how uncertain and anxious the markets are at current levels of interest rates. There is not much the ECB can, or should, do about this — except give clear guidance about its reaction function.

It looks unlikely that inflation will rebound quickly. A more probable trajectory is a gradual and moderate recovery throughout 2015 and 2016. Assuming 10-year US Treasury yields of 2.5-3 per cent for the rest of the year as well as continued accommodation by the ECB, 10-year Bund yields should not rise much above 1.25 per cent over the six-month horizon.

When the end of the bond purchase programme nears — which I would expect to happen in the first half of 2016 — rates will rise further and reach around 2 per cent at year-end. That they will overshoot or undershoot on the way is almost certain.

© Financial Times