Understanding the ECB’s Sequencing Program

With the eurozone economy now on a firmer footing, the focus has shifted toward how the European Central Bank (ECB) will navigate its exit from unconventional monetary policy, says Kenneth Orchard from T. Rowe Price.

These quence of actions it will undertake, from the reduction of its quantitative easing program to the increase in interest rates, and the speed at which this will happen were key discussion points raised by the global investment team during its latest investment policy meetings.

Faced with the possibility of deflation taking hold in the eurozone, the ECB adopted a negative interest rate policy in 2014 and launched a full quantitative easing program the following year. But now that the eurozone economy is strengthening and policymakers have acknowledged that deflation risks have disappeared, there is a growing number of questions about the need to keep monetary policy measures so easy. "The persistence of strong economic growth has focused attention on the ECB’s exitfrom quantitative easing and the first rate hikes,” said global fixed income Portfolio Manager Kenneth Orchard.

To a certain extent, the ECB has already started taking its foot off the accelerator. In March, the central bank offered its final round of low-cost loans to banks in a program known as the targeted longer-term refinancing operations. Then, in April, the ECB reduced the pace of its monthly bond-buying program by €20 billion to €60 billion. So what happens next?

There is an expectation that the ECB will announce a rapid tapering of its bond-buying program this September. "Markets see a fast tapering scenario as negative for eurozone government bonds," added Kenneth Orchard, "but European fixed income could find support as the pace of reduction is likely to be slower than anticipated."

Investors also take for granted that the announcement will come in September, but here again, they may end up being disappointed. "It’s more likely the ECB waits until October’s meeting. Inflation is of no concern, and the German election is happening in September,” noted Orchard. This, in turn, pushes any potential rate hike back further to 2019.

Another possibility is that the ECB takes a more aggressive approach, the team noted. This could involve reducing its bond-buying program quicker each month or even raising interest rates before quantitative easing ends. Either scenario—or a combination of both—would likely put yields on eurozone government bonds under pressure. Such an outcome could also generate opportunities, however. In particular, there’s potential for a steady appreciation of the euro and the relative outperformance of the financials sector within credit markets.

To determine which option the ECB might choose, it’s important to assess the underlying dynamics of the eurozone economy. While eurozone growth has accelerated and unemployment is falling, inflation remains weak, and it’s unlikely to move sustainably close to its target for at least another two to three years.

"It’s important to remember that the ECB targets inflation, not growth. As inflationary pressures remain weak, we expect the ECB to cautiously withdraw stimulus, with no rate hikes for the foreseeable future,” said Kenneth Orchard. "A rapid, Fed-style taper that some market participants are anticipating with quantitative easing ending by the middle of next year is therefore unlikely," concluded Orchard.