European Central Bank faces a Trump quandary

Posted on November 22, 2016

At the Bundesbank’s Frankfurt offices, its dealers sit in front of rows of Bloomberg and Reuters terminals and search for €10bn-worth of their government’s bonds to buy each month. As prices for the debt hit record highs earlier this year, they struggled to find bonds cheap enough to meet their target, set as part of the European Central Bank’s quantitative easing programme.

Now, as investors anticipate higher inflation and growth under Donald Trump’s US administration, demand for government bonds — including Germany’s — is no longer so high. The rise in Treasury yields has pushed borrowing costs up on the other side of the Atlantic, reflecting the dominance of the US government’s debt in global capital markets.

Yet, while Mr Trump’s victory has made life easier in central banks’ dealing rooms, the rise in borrowing costs for the region’s governments threatens to become a problem for the eurozone’s monetary policymakers.

The upset has shifted the balance in favour of a more aggressive stimulus package in early December, when the policymakers meet across town at the ECB, a few miles to the south-east of the Bundesbank’s headquarters.

The US Federal Reserve is preparing to raise rates, but the eurozone’s economy remains in poor shape. Central bankers here have bought about €1.4tn-worth of mostly government bonds since March 2015 to revive the region’s economic fortunes, but inflation is still weak and unemployment in double figures.

Where the QE programme has succeeded is in lowering borrowing costs for Europe’s businesses and households, and making credit more easily available to riskier borrowers. Mr Trump’s victory threatens the opposite trends.

Historically, higher US borrowing costs have often pushed up interest rates in Europe. This time around the threat is greater.

Mr Trump’s win has added to a more general mood of uncertainty. With Italy, Germany, France and the Netherlands facing crucial votes of their own over the next 12 months, a big risk for the ECB is that a rise in nationalism will raise fresh doubts about the viability of the single currency area.

One of the successes of eurozone QE was to send “financial fragmentation”, a phrase used by ECB president Mario Draghi to describe the gulf in borrowing costs in stronger economies such as Germany’s and weaker member states such as Italy, into reverse. With investors becoming more mindful of political risks, the gulf is widening.

Yields on Italian 10-year bonds have risen 70 basis points over the past month — more than double the rise in Bunds — as fears rise of a “no” vote against prime minister Matteo Renzi in the Italian referendum on constitutional reform on December 4.

Didier Saint-Georges, a managing director at fund manager Carmignac, said dollar investors were likely to switch into German assets to protect against the foreign exchange risk of a break-up of the eurozone. “US investors need to think twice before investing in Europe as elections unfold one after the other,” he said.

The eurozone’s policymakers will gather on the 41st floor of the ECB on December 8 to decide what to do after March 2017 — the deadline for the current stage of QE, which involves buying bonds worth €80bn a month.

With markets still in flux, clues are scant on what comes next. But if government borrowing costs continue to rise, the chances fall that the ECB will do what is known in central bank-speak as tapering and slow the pace of its bond buying.

“The current level of yields is fine. But any hint at tapering could trigger a much bigger sell-off in eurozone bonds,” said Carsten Brzeski, economist at ING DiBa bank. “Before the election of Mr Trump, an elegant solution could have been to extend QE but buy bonds at a slower pace. This will not work in a climate where financial markets are extremely nervous. The ECB will have to carry on buying €80bn of bonds a month for at least another three to six months beyond March.”

Mr Brzeski added: “Maybe monetary policy is too loose. But the damage that tapering too early could cause is much bigger than the dangers of doing a little too much.”

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