The European Central Bank is casting a shadow on the euro zone economy in the New Year as it shuts down its asset purchase program, depriving financial markets of a monthly injection of liquidity.
The ECB has been tapering off its purchases, going from a peak of €80 billion ($91.5 billion) a month in 2016 to 2017 to €15 billion in the fourth quarter of 2018. But the bank intends to reinvest the principal of maturing bonds in its €2.6 trillion portfolio well into 2020. Since it also won’t raise interest rates until this autumn at the earliest, its monetary policy could hardly be called restrictive.
Nonetheless, the prospect of the central bank withdrawing this support for government bonds has already buffeted bond markets. In particular, the price of Italian government securities has dropped significantly, and the absence of the ECB buying new bonds will further widen the gap in yields, or annual returns, between Italy and Germany. Italian long-term bonds now yield close to 3 percent, compared to less than a quarter-percent for German bonds.
The euro's soft underbelly
The ECB action, as small as it seems, exposes all the vulnerabilities of the euro system, and creates uncertainty in the market about the future of the joint currency. Added to that is the departure this year of Mario Draghi, the ECB president whose pledge in 2012 that the bank would do whatever it takes to preserve the euro saved the currency on the strength of his word alone.
“It is altogether possible that investors are underestimating the full extent of potential risks in Europe,” said Michael Hasenstab, global bond strategist for US asset manager Franklin Templeton. “We are presuming that in the coming year the euro will continue to be vulnerable in the face of unresolved structural and political risks.”
Chief among these is the so-called “doom loop” between banks and governments, because lenders tend to hold a lot of domestic government bonds. In Italy, this means that declining bond prices further weaken the already fragile banks, creating the possibility of a banking crisis on top of a government debt crisis.
Breaking the vicious cycle
The ECB’s asset purchases have provided some cover for Italy. Rome has steadily increased its debt to 131 percent of gross domestic product, more than double the 60 percent maximum allowed under euro rules. Without that extra demand from the central bank, investors may balk at buying fresh Italian debt, leading to the vicious cycle of higher yields and erosion of bank balance sheets.
Economist Isabel Schnabel, a member of the German government’s economic advisory panel, recently tweeted her wish for a reform package that would break the link between banks and government debt, improving fiscal discipline while contributing to stability.
But these reforms have been difficult to come by. Berlin has resisted measures that could lead to German taxpayers bailing out Italian banks, while the populist Italian government is tired of waiting for EU reforms to provide relief for its citizens.
Less wiggle room for ECB
The European drama is not taking place in a vacuum, either. The US is nearly three years ahead of Europe in the monetary policy cycle. The US Federal Reserve has not only ceased buying new bonds but is gradually running off its portfolio. At the same time, it has been steadily increasing interest rates.
This tightening of the monetary screws has thrown the US economy and markets into a tailspin, so that analysts now believe the Fed will back off any further tightening this year and perhaps even reverse course.
Having raised its benchmark overnight rate to between 2.25 and 2.5 percent, the Fed has room to cut rates again – one of the reasons it started raising rates when it did in 2015. The ECB, which has kept its main refinancing rate at zero, has no such leeway, leading analysts to believe it will delay any interest rate hikes, perhaps into 2020.
Once again, the question of who will succeed Draghi becomes central to forecasting central bank action. Bundesbank President Jens Weidmann is still in the running, but Berlin has indicated a willingness to let the ECB presidency go in exchange for some other EU post, such as president of the European Commission.
French central bank governor François Villeroy de Galhau is another candidate, although France has already had one of the last three ECB presidencies. Two Finns, former central bank governor Erkki Liikanen, and the current governor and former European commissioner Olli Rehn, are spoken of as possible compromise candidates.
In any case, the bank that Draghi built as a bulwark of defense for the euro will again play a critical role in 2019 as it seeks to preserve the European project and support the continent's economy.
Jakob Blume, Andrea Cünnen, and Frank Wiebe are financial correspondents in Handelsblatt’s Frankfurt bureau. Darrell Delamaide adapted this article into English for Handelsblatt Today. To contact the authors: [email protected], [email protected], and [email protected]