Tapering, Not Tightening

by: Neuberger Berman

By Patrick Barbe and Jon Jonsson, Senior Portfolio Managers, Investment Grade Fixed Income

Why we don’t expect the ECB’s withdrawal of QE to throw euro bond markets off balance.

Today's CIO Weekly Perspectives comes from guest contributors Patrick Barbe and Jon Jonsson, Senior Portfolio Managers in Investment Grade Fixed Income.

At its most recent meeting, the European Central Bank confirmed that it will phase out its bond purchase program at the end of the year. Many investors worry that this could pose a challenge for euro bond markets because risk premiums are still low, in large part due to the success of that program of quantitative easing. But is it really likely to knock them off balance?


QE began in the eurozone in 2015, and has encompassed purchases of government, covered and corporate bonds. In parallel, the ECB offered low-rate funding to banks via its targeted longer-term refinancing operations (TLTRO).

The result is that all euro bond sectors are under the influence of QE: The ECB holds 22% of government bonds and 9% of corporate bonds, while banks have significantly reduced their senior bond issuance in favor of TLTRO. The policies are holding credit spreads near their lower bound and have created a scarcity of AAA-rated government bonds.

That scarcity justifies the phasing out of the bond purchase program. In addition, the central bank's own analysis has concluded that its balance sheet size matters more than the fact or the speed of its growth through bond purchases. The introduction of QE pushed rates negative immediately in 2015, but the eurozone's growth rate only began to accelerate late in 2016 when the ECB's balance sheet passed €2 billion. It required a long period of cheap funding before businesses recovered confidence and restarted their investment plans.


The balance sheet will still be large even after QE ends. Moreover, ending QE does not signal an overall tightening of policy.

The ECB reiterated its forward guidance that interest rates would remain negative at least through next summer. While prices and wages have been picking up, the ECB is still some ways from getting eurozone inflation close to its target of 2%. Low inflation has resulted partly because QE and negative rates have not weakened the euro as much as might have been expected; the impact was temporary, and in 2018 it has been trading back at its average level.

The advantage of a stable currency and low inflation risk is that it likely gives the ECB breathing space to maintain its large balance sheet and its negative policy rates in order to keep bond yields low and credit spreads tight.

This is critical to support the ongoing recoveries across the eurozone; the restoration of bank lending and small and medium-sized business confidence has only just begun in southern Europe. That, in turn, would support the goal of preventing systemic risk and contagion. It is notable that the political tensions in Italy this year did not spill over into other countries' asset markets.

While primary flows ahead of the phasing out of the corporate bond purchase program may widen euro credit spreads as we move into October, we anticipate that, combined with ongoing loose policy, these few extra basis points will likely attract flows from yield-seeking investors. The reinvestment of proceeds from bonds maturing on the ECB's balance sheet is also likely to help market pricing to adjust smoothly. We envision that the 10-year German Bund yield could rise toward 0.75% at the end of this year and then potentially up to 1% in 2019, subject to the path of inflation.

Relative Value

At the global relative-value level, we therefore consider market pessimism towards Europe to be overdone. Growth has disappointed this year relative to the unsustainable levels it reached in 2017, but it remains above trend; the euro is cheap against the dollar, financial conditions are still loose and the ECB leans toward the accommodative. A tariff war could hurt eurozone exports, but they are well-diversified, geographically, and there is no sign of trade tensions stalling Europe's upward capex trend.

By contrast, super-bullish risk premiums are priced into U.S. assets despite uncertainties around the strong dollar, the pace of rate hikes and the fiscal clean-up required once tax policy stimulus wears off.

Within euro markets, we find it appealing to be short duration in core and semi-core rates by limiting exposure to the long end of yield curves, and we remain cautious on credit running into the phase-out of the QE program. Nonetheless, we view tactical exposure to Italian bonds as attractive now; and, over the medium term, we believe concerns about a big rise in yields and a blowout in credit spreads as the ECB withdraws from these markets to be significantly overstated.

In Case You Missed It

  • Eurozone Consumer Price Index: +0.2% in August month-over-month and +1.0% year-over-year
  • NAHB Housing Market Index: No change at 67 in September
  • U.S. Housing Starts: +9.2% to SAAR of 1.28 million units in August
  • U.S. Building Permits: -5.7% to SAAR of 1.23 million units in August
  • Bank of Japan Policy Rate Decision: BoJ made no changes to its policy stance
  • U.S. Existing Home Sales: Unchanged at SAAR of 5.34 million units in August
  • Japan Consumer Price Index: +1.3% year-over-year in August
  • U.S. Purchasing Managers' Index: +0.9 to 55.6 in September
  • Eurozone Purchasing Managers' Index: -1.3 to 53.3 in September

What to Watch For

  • Tuesday, 9/25:
    • S&P Case-Shiller Home Prices Index
    • U.S. Consumer Confidence
  • Wednesday, 9/26:
    • U.S. New Home Sales
    • FOMC Meeting
  • Thursday, 9/27:
    • U.S. Durable Goods Orders
    • U.S. 2Q 2018 GDP (final)
    • China Purchasing Managers' Index
  • Friday, 9/28:
    • U.S. Personal Income and Outlays

- Andrew White, Investment Strategy Group

Statistics on the Current State of the Market - as of September 21, 2018

Market Index WTD MTD YTD
S&P 500 Index 0.9% 1.1% 11.1%
Russell 1000 Index 0.7% 0.9% 11.0%
Russell 1000 Growth Index -0.1% -0.1% 16.3%
Russell 1000 Value Index 1.4% 1.9% 5.7%
Russell 2000 Index -0.5% -1.6% 12.5%
MSCI World Index 1.6% 1.2% 6.6%
MSCI EAFE Index 2.9% 1.8% -0.1%
MSCI Emerging Markets Index 2.3% -0.3% -7.2%
STOXX Europe 600 2.5% 1.7% -0.9%
FTSE 100 Index 2.6% 0.9% 0.7%
TOPIX 4.4% 4.0% 0.4%
CSI 300 Index 5.2% 2.4% -13.5%
Fixed Income & Currency
Citigroup 2-Year Treasury Index 0.0% -0.2% 0.1%
Citigroup 10-Year Treasury Index -0.6% -1.7% -3.9%
Bloomberg Barclays Municipal Bond Index -0.4% -0.8% -0.6%
Bloomberg Barclays US Aggregate Bond Index -0.3% -0.8% -1.8%
Bloomberg Barclays Global Aggregate Index 0.1% -0.3% -1.9%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.1% 0.4% 3.7%
ICE BofA Merrill Lynch U.S. High Yield Index 0.1% 0.4% 2.3%
ICE BofA Merrill Lynch Global High Yield Index 0.4% 0.8% 0.5%
JP Morgan EMBI Global Diversified Index 0.5% 0.8% -3.7%
JP Morgan GBI-EM Global Diversified Index 1.6% 1.6% -9.0%
U.S. Dollar per British Pounds 0.2% 0.8% -3.2%
U.S. Dollar per Euro 0.8% 1.1% -2.1%
U.S. Dollar per Japanese Yen -0.4% -1.5% 0.1%
Real & Alternative Assets
Alerian MLP Index -0.5% -0.2% 7.3%
FTSE EPRA/NAREIT North America Index -0.4% -1.5% 3.5%
FTSE EPRA/NAREIT Global Index 0.5% -0.8% 0.8%
Bloomberg Commodity Index 2.4% 0.9% -3.0%
Gold (NYM $/ozt) Continuous Future 0.0% -0.4% -8.2%
Crude Oil (NYM $/bbl) Continuous Future 2.6% 1.4% 17.1%

Source: FactSet, Neuberger Berman.

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