In the context of the improved global economic situation, non-standard measures or quantitative easing (QE) put in place by central banks to revive economic activity seem less justified. However, withdrawing from QE requires forward guidance to limit the negative impacts on securities markets and avoid a mechanically recessive effect.
Following the 2008 financial crisis, the ECB drastically reduced its interest rates to sustain activity, reaching negative interest rates. However standard growth revival policies did not work, and the European economy was confronted with a real liquidity trap, like Japan in the late 1990s. In addition, the ECB had to deal with the banking crisis (subprime mortgage crisis) and the sovereign debt crisis (pressure on eurozone country payment balances). As a result, from 2009, and then with a sharp acceleration from 2015, it opted for a widespread policy to purchase debt securities on the financial markets.
This programme covers several types of financial assets: covered bonds (CBPP), State and public entity securities in the eurozone (SMP, PSPP), asset-backed securities (ABSPP) and finally corporate securities (CSPP). By the end of March 2018, the ECB held over 2300 billion euros in securities. Its policy has met the following targets: reducing the risk of deflation, avoiding a credit crunch and reviving growth in the eurozone. The core inflation rate remains low, notably held back by stagnating wages. However, the ECB has slowed down its purchases and is preparing the markets for the gradual normalisation of its monetary policy and the imminent end of QE.
On the rates and credit markets, the situation has become complicated. After a period of strong compression of credit spreads and falling rates, investors are looking at how to approach normalisation. Indeed, reduced liquidity, widening of rate spreads and strong corrections on the securities market, and perhaps a bear flattening of the euro rate curve (similar to the one observed on the US rate curve during the recent Fed rate rises) could all occur in the future.
However various medium-term strategies are available to investors: reducing the average maturity of portfolios, gradually reducing the share of high yield securities in the securities allocation, and using securities indexed to inflation. A much more dynamic approach should be prioritised with derivatives: the first quarter of 2018 showed that short volatility strategies were quite inadequate, and that the gradual use of optional strategies (CDS or indices) and futures on rates to reduce the overall duration of portfolios seems quite appropriate.
With QE, the ECB has removed capital scarcity and could have caused “the euthanasia of the rentier” on a large scale. The questioning of public debt as a “safe asset” and the movement of investments to high yield assets has increased the volatility of securities markets. But if risk premiums were to increase significantly, the relevance of the ECB’s role as buyer would be called into question.
Originally published by Philippe Wenden (Compagnie Monégasque de Gestion) at Monaco for Finance