ECB yield troubles may ease with some help from Yellen

As European Central Bank (ECB) President Mario Draghi wonders how to keep his bond-buying programme going, a little help from Janet Yellen might be welcome.
The Federal Reserve Chair will lead her colleagues to a US interest-rate decision today that has implications for the ECB’s plan to ensure its own quantitative-easing programme has enough assets to buy. Even if Fed policymakers don’t raise rates immediately, any sign that they’re prepared to do so this year could lift global yields – and that’s a bonus for the ECB.
Draghi’s pledge to spend €1.7tn ($1.9tn) on quantitative easing through March 2017, and to keep going if needed to revive inflation, faces a key problem: euro-area bond yields are so low that a significant portion of debt is ineligible for purchase under the ECB’s own rules. Fed hawkishness would help ease that constraint, and while the effect might be small, it could buy the Governing Council some time as it considers how to keep the program alive.
“A rate increase would be an expression of confidence,” said Stefan Schneider, chief international economist at Deutsche Bank in Frankfurt. “A slight increase in US yields in response would also have an impact on the European bond market. It could help the ECB in increasing the pool of purchasable assets, but I wouldn’t be euphoric.”
Almost €1.4tn of euro-area debt currently have a yield below the deposit rate of minus 0.4%, the minimum required for eligibility for QE. The rule is one of several created by the ECB to mitigate concern that it’s taking on too much risk or exceeding its mandate.
While US officials will probably keep rates unchanged for the sixth consecutive meeting, they’ll also strengthen guidance about their intentions to raise borrowing costs soon, according to economists in a separate Bloomberg survey.
Even so, Yellen can’t be Draghi’s saviour. For a start, a sell-off in government bonds earlier this month is already waning ahead of the meeting, for which futures traders are pricing in just a 20% chance of a rate hike. Recent readings from the US economy have been mixed. Sales at US retailers and factory output dropped more than forecast in August, while job gains continued. Inflation has been below the 2% target for more than four years.
That US picture, adding to a global outlook clouded by the UK’s vote to quit the European Union and a bad-loan crisis in Italy, raises the risk that the ECB will need to do more on QE.
“If they’re sitting there hoping that the Fed is going to solve the scarcity problem they’re kidding themselves,” said Richard Barwell, an economist at BNP Paribas Investment Partners in London. “The ECB will have to pick their poison: What’s the least unattractive option?”
Another central bank to watch is the Bank of Japan on the same day, several hours before the Fed, when officials will give the results of a review of their ultra-loose monetary stance. The uncertainty surrounding that decision has the potential to roil bond markets.
After the last policy meeting on September 8, Draghi said that the central bank’s committees have been given a “full mandate” to consider how to improve the implementation of QE under what he called the “new constellation” of rates.
Yet that evaluation could provoke fractious debates in the Governing Council. Bundesbank President Jens Weidmann and Executive Board member Sabine Lautenschlaeger – both from Germany – have already warned against deviating from the capital key, a stipulation that purchases are allocated roughly proportional to the size of each economy.
Another solution, seen as gaining traction with policy makers, is to scrap the rule on minimum yields. While that might expose national central banks to losses, they could make them up elsewhere.
The day after Draghi spoke, Governing Council member Ilmars Rimsevics said the QE review will last until December. That’s just three months before the current buying schedule expires, and suggests that no new stimulus measures will be announced at the next meeting in October. Disappointed investors have sold off euro-area bonds since September 8, ironically pushing up yields and reducing the probability that the central bank will run out of eligible assets.
The risk though is that disappointment will turn into nervousness and market tensions severe enough to hurt the euro- area recovery. Economists surveyed by Bloomberg see an extension of QE as inevitable, even if only to avoid an abrupt halt by gradually reducing purchases.
“If yields stay where they are and the ECB doesn’t extend QE, it would probably be able to just about finish its program,” said Michael Schubert, an economist at Commerzbank in Frankfurt. “But because nobody expects the ECB to stop purchases abruptly, with the weakest form of extension being tapering, they need to do something.”