Since the start of the financial crisis, central banks across the world, amongst them the ECB, have introduced extraordinary measures to support the global economy and financial markets. They have been increasing their balance sheet by buying government and corporate debt, covered bonds and ABS.
In addition, key central bank rates have been cut to historically low levels. Withdrawal of this very accommodative policy will have important consequences for financial markets in general and fixed income markets in particular.
Risk of interest rate rise
Generally speaking, fixed income portfolios exhibit positive duration and will move inversely with interest rates. When interest rates rise, the value of fixed rate bonds will drop, especially bonds with a very long maturity profile. Floating rate securities on the other hand, such as ABS, have negligible duration risk as these bonds are indexed at Euribor plus a pre-defined margin and will not move (or will even move up) when rates rise.
Fixed income portfolios are at risk of a (sharp) rise in global interest rates, something which until now has not been much of a concern due to central bank stimulus. However, with the US Fed increasing rates and reducing monetary stimulus, the ECB tapering their bond buying since March and hinting at a further reduction, an interest rate increase in the eurozone is a possibility.
ECB monetary policy
The ECB has an arsenal of monetary policy tools but mainly use their money supply control and interest rate setting tools. There are three rates that the ECB controls. The ECB deposit rate is currently being watched most closely considering rate setting. This rate’s target is currently set at -0.40%. This means that a bank pays 40bps in order to be able to store excess liquidity at the ECB overnight. Euribor has fluctuated in a range of 0-30bps of the deposit rate and the difference between these rates is a measure of the excess liquidity in the system and Euribor is currently at around -0.33% leaving a spread of 0.07% above the ECB deposit rate. The second tool, control over the money supply, has caused the balance sheet of the ECB to increase to €4.28tn, which is close to 38% of nominal Eurozone GDP. The Asset Purchase Program (APP) is part of the balance sheet. The total amount of assets purchased under the APP amounts to €2,075bn at the end of August (at amortized cost) and is composed of sovereign bonds (82.1%), covered bonds (11.6%), corporate credit (5.2%) and ABS (1.2%).
Tapering does not stop central banks from reinvesting
This same range holds for the Fed funds rate and US Libor. When the US Fed raised their policy rate in December 2015 and again in 2016 and 2017, Libor moved from 0.35% to 1.35%, staying within a range of 10bps from the Fed funds rate. Before increasing the Fed Funds rate, the US Fed started tapering their QE bond buying program by $10bn a month in January 2014, down from $85bn per month, and concluded their bond buying in October 2014. Over the course of their bond buying programs, the Fed’s balance sheet increased to $4.5tn (close to 23% of nominal US GDP).
While the US Fed ended their QE bond buying program in 2014, they have only recently started to discuss reducing or even abandoning the reinvestment of coupons and maturing bonds. The ECB has started tapering their asset purchases in March 2017 by reducing their monthly buying from €80bn to €60bn, but continue to reinvest maturing bonds. This shows that QE programs of central banks can continue in some form even long after the end of such programs. We expect the ECB to continue to reinvest the coupons and the proceeds of maturing bonds after they stop the direct buying of bonds.
Reading between the lines of ECBs messages, it seems that their gauge of the amount of monetary stimulus needed has shifted from looking solely at inflation numbers, which are still lagging the 2% target of the ECB, to focus more on growth figures and the growth outlook. This is in line with the most recent statement of the Fed which indicated that inflation concerns have declined and a third rate hike this year is not unlikely. The current monetary policy does add to inflationary pressure, however, and inflation has increased recently. Moreover, the eurozone economy is performing quite well. Economic growth is at 2.2%, supported by a significant reduction in political risk last year and economic momentum, as reflected by improvements in the labor market.
The withdrawal of monetary stimulus will result in reduced demand from the ECB and will have the biggest impact on spreads (yields) of sovereign bonds, covered bonds and corporate credit.Egbert Bronsema
Overall it seems that after years of extremely accommodative policy, the global economy in general and the eurozone in particular looks more robust and has improved enough to handle reduced stimulus. The ECB is therefore not likely to deviate far from the monetary policy of the US Fed in their removal of stimulus and the rate hike path. This means that we expect the ECB to start withdrawing (at least part of) its monetary stimulus in the coming months. An increase in policy rates, such as moving the deposit rate to zero and a subsequent move in Euribor, is on the horizon. Keeping the composition of the APP in mind, the withdrawal of monetary stimulus will result in reduced demand from the ECB and will have the biggest impact on spreads (yields) of sovereign bonds, covered bonds and corporate credit. ABS on the other hand has not been a large part of the ECB’s holdings and their withdrawal will not affect spreads on ABS. In addition, a move in Euribor will increase the coupon of floating rate securities and will therefore not result in a decrease in price.
Despite positive numbers coming from different parts of the markets, investors are still quite surprised by central banks’ messages. German BOBLs (securities issued by the German government with a term of around 5 years) for example rose 20-30bps after hawkish notes of several central banks after the annual ECB meeting in Portugal in June 2017. This is particularly worrisome as higher duration of bond portfolios has intensified in the last few years as Eurozone governments decided to issue relatively longer-dated bonds. The average duration of Belgian government bonds increased from 6.75 years to over 9 years since 2013 (with Austria most recently issuing a 100 year bond). Not just eurozone governments have used the low yield environment to issue new bonds with a (much) longer maturity, but duration in the corporate debt market has risen as well.
Investors are not compensated for the increased duration risk. Yields are at their all-time low and carry is not sufficient to cover for this risk. Once the ECB decides to cut its purchases or increase rates, yields will rise and fixed income portfolios will be hit by reduced demand and increased interest rate risk. Asset allocation strategies and active portfolio management can mitigate the effect of negative returns on fixed income portfolios. Floating rate securities, such as ABS, decrease duration risk and are a natural hedge against (the anticipation of) rising rates. We expect demand from fixed income investors for floating rate securities, such as ABS, to increase in anticipation of rising rates. Keeping in mind the 1.2% exposure to ABS in the APP, the impact on spreads due to the reduced demand from the ECB will be limited.