The beatings will continue until morale improves, the saying goes. That's one interpretation of the European Central Bank's somewhat convoluted rejig of its quantitative easing program this week.
By insisting he's not tapering bond buying while simultaneously reducing the monthly purchases and extending the time frame, President Mario Draghi is sending a mixed message that likely reflects disagreements among his Governing Council members. Cutting the program to 60 billion euros ($64 billion) per month from 80 billion euros throws a bone to those who worry that it's time to withdraw the monetary medicine; lengthening the timeline until the end of next year pacifies policy makers who fear the patient isn't yet on the road to recovery.
But in financial markets, bond yields are effectively tightening monetary conditions on the central bank's behalf, suggesting investors are beginning to anticipate an improved economic outlook. That could play out in two ways: Either bonds are correct, and the ECB will find itself tapering properly next year, or bonds are wrong, in which case Draghi will have to make good on his pledge to do more if needed.
The 10-year German bond yield has climbed to about 0.4 percent from a low of almost -0.2 percent in July. That's still a ridiculously low level; the average in the past two decades is about 3.4 percent, and for most of the 1990s the range was between 5 percent and 9 percent. Nevertheless, it amounts to a significant tightening in monetary conditions in just three months as the yield curve has steepened:
Also, don't forget that the euro zone remains a fractured economic landscape. Germany, with an unemployment rate of 6 percent, will find it easier to withstand rising borrowing costs than Italy, where the jobless rate is almost twice as high. And the Italian yield curve has replicated the move seen in Germany, at higher levels that have doubled 10-year yields to 2 percent since August:
With 15 basis points of that move in 10-year Italian bonds coming in the wake of the Thursday ECB announcement, it's pretty clear that bondholders are viewing this week's reshuffle as a form of tapering, no matter what Draghi says. Other European markets suffered even more, with Portugal's 10-year borrowing cost soaring by 20 basis points to 3.75 percent Thursday.
With Draghi saying that "the risk of deflation has largely disappeared," the shift in bond yields in large part reflects investor anticipation of rising consumer prices. Draghi's favorite measure of future inflation is certainly showing signs of life; the five-year, five-year forward inflation swap rate climbed above 1.7 percent this week for the first time in more than a year. While that leaves it below the ECB's 2 percent target, the rate is up from a low of 1.25 percent in July. And the actual annual consumer price gauge has also headed higher, with November's 0.6 percent rate registering the fastest pace since April 2014:
Draghi says the 1.7 percent inflation rate the ECB is forecasting for 2019 still means the central bank isn't really meeting its goal. But it still points to a better result than the negative numbers that prevailed for much of 2015 and 2016. While Draghi's current reticence is understandable, he should be looking forward to reducing the ECB's reliance on unconventional policy measures. The moves in the bond market suggest QE's days are indeed numbered and that tapering should be the next policy move.
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