We knew it had to come at some time, but the elusive question has always been when? The question we refer to is when the European Central Bank (ECB) would finally signal that they were going to ease off of ultra-stimulative monetary policy. At the late June press conference ECB President Mario Draghi took the first step, albeit a tiny one, and hinted that quantitative easing could be tapered at some point in the future. Recall that when the Federal Reserve first broached the subject of pulling back from emergency monetary policy in 2013, investors staged what has been dubbed a “taper tantrum,” in which the U.S. 30-year Treasury yield skyrocketed by 110 basis points in the two months that followed. Compared to the U.S., the Europeans reaction was far more muted. Since Draghi’s comments, the German 30-year yield is 38 basis points higher and the DAX index of German stocks is less than 1% away from its all time high. Hardly a tantrum! Nonetheless, a day after the comment, ECB sources said that markets took the words out of context and that the central bank is not currently considering reducing the stimulus program.
Further adding to investor confusion, Bank of England Chairman Mark Carney explicitly said that the U.K Central Bank would need to raise interest rates in the not too distant future. Moreover, he described the global recovery as having become “broad-based.” Although, he followed that by saying the BOE would “wait and see” how the economy develops which we translate as suggesting that a rate hike will not occur this summer. Rounding out the suddenly hawkish tone of policy makers, Carney’s previous employer, the Bank of Canada raised their overnight lending rate for the first time in seven years this month.
Undoubtedly, the comments and actions of the various Central Banks are a departure from the accommodative policy that’s been in place since the financial crisis. However, we anticipate that they’ll follow the Federal Reserve and reverse policy at a glacial pace. Despite that, we expect that market volatility will likely tick higher as investors attempt to decipher how soon and by how much interest rates will rise. In doing so, it’s important to understand that as global central banks begin to back away from emergency monetary policy they are not actually tightening policy. The ECB and BOE are suggesting that they will slow their buying of assets while the Fed is planning on reinvesting less of the interest and maturity payments generated from their portfolio. All three will continue to buy assets in the open market, thereby impacting prices and keeping interest rates artificially low. It they were to endeavor to tighten policy, they would be outright sellers of securities held in their portfolio.
The Fed laid out its plan for balance sheet reduction at the conclusion of the last FOMC meeting. Their plan is to trim reinvestment by $10 billion in the first three months after implementing the operation (when that will be has not been communicated), with the reduction split between Treasury notes and mortgage-backed securities, 60% and 40% respectively. They plan on increasing that amount to $20 billion in the next quarter, and continuing to increase by $10 billion each quarter, until they top out at $50 billion a quarter. The stated intention is to keep the 60%/40% ratio throughout the operation. When the Fed ultimately reaches $50 billion a quarter, the annual amount of proceeds not reinvested will represent about 4.5% of their total portfolio. Of course, they will be shrinking the portfolio at about half that rate because their existing holdings will continue to generate income of about 2% a year on the remaining balance. The point is that it’s unlikely that the Fed portfolio will return to pre-crisis levels for a very, very long time.