Balance sheet reduction casts its shadow ahead
The ECB has been forced to frontload monetary tightening to prevent inflation expectations from becoming unanchored even if this means pushing the euro area into recession. They understand that it is essential to soften labour markets enough to prevent a wage/price spiral. The risk of doing too little is much bigger than the risk of doing too much. Markets have understood the ECB’s reaction function and have priced a substantial rise in policy rates, pushing long-term rates to highest level in 10 years.
Additionally, the ECB Governing Council is likely to discuss ways to reduce the ECB’s balance sheet to directly remove excess liquidity from the system. Commercial euro area banks will probably hold on to most of their TLTROs unless the ECB worsens their terms retroactively (which we think is unlikely). Hence, a reduction of bond holdings from its Asset Purchase Programme (APP) is the most straightforward way to achieve the objective. Although nothing concrete has emerged so far, the most likely way forward is a passive roll off of maturing positions starting in the first half of 2023. This implies that maturing bonds on the balance sheet will only be partly reinvested. The ECB has little experience with Quantitative Tightening (QT), and has to manage the potential risk of fracturing euro area government markets, which demands a cautious approach. Nevertheless, QT is a blunt instrument, which can be very impactful. The UK is a prime example for what can happen if it is not adequately prepared.
When a central bank performs Quantitative Easing (QE), it essentially buys bonds from private sector balance sheets and replaces them with deposits, thus freeing up liquidity to buy risk assets and duration. The end of asset purchases and the onset of QT achieves the opposite, that is, it replaces deposits with bonds on private sector balance sheets, thus ‘destroying’ funds to buy risk assets, but also duration. There are undoubtedly negative effects for bonds from significantly increased expected supply in the short term, the current build-up of (real) risk premia does at least partly reflect this. But the tightening of financial conditions associated with QT and its negative impact on the economic cycle suggests that this effect will likely prove to be temporary. The negative impact on risk assets, on the other side, is likely more pronounced.
In fact, financial conditions in the euro area have been tightening substantially over the past few months, at a speed that is reminiscent of the euro crisis. The drivers for tighter financial conditions are manifold (and partly interlinked): (1) sharply higher real government bond yields in all euro area markets; (2) substantially wider swap-spreads to core euro area markets; and (3) corporate credit spreads, but also increasing peripheral spreads.
The repricing of European rates structures is probably not over yet. The persistence of high inflation rates despite a sharply weakening cycle raises uncertainty with regard to the appropriate magnitude of tightening and a sufficient level of (real) risk premium to account for net additional supply and ongoing rates volatility. The risk that financial conditions tighten too much, with negative implications for risk assets, is increasing. For that reason, government bonds will likely be the first ‘risk asset’ to turn around.
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