Domestic Bonds

ECB to start discussions on shrinking its balance sheet amid bond market turmoil

The European Central Bank is set to begin the delicate process of shrinking its balance sheet this week after eight years of generous bond purchases and loans that have more than quadrupled its total assets to 8.8 billion euros.

The change would mark an intensification of the ECB’s efforts to remove monetary stimulus and calm inflation, which hit a record high of 9.9% in September in the 19 countries that share the single European currency, almost five times its target of 2%.

Policymakers must proceed with caution or risk a UK-style bond market sell-off that would compound the economic problems facing the region. “It is going to be a difficult semester for the ECB, during which many potential trade-offs between inflation, growth and financial stability could become more intense and difficult to manage,” said Silvia Ardagna, senior European economist at Barclays.

Thursday’s ECB Governing Council meeting in Frankfurt is expected to agree to an interest rate hike, almost certainly by 0.75 percentage points for the second consecutive time. That would take its deposit rate to 1.5%, its highest rate since January 2009.

Several members of the council, led by ECB President Christine Lagarde, said they also plan to discuss ways to start cutting the balance sheet, which has exploded over the past decade from around 2 billion euros to a figure equivalent to 70% of the euro area. gross domestic product.

The markets have become accustomed to generous support from the ECB. Removing this stimulus as the euro zone is dragged into recession by an energy crisis and investors worry about high debt levels in southern European countries could be a recipe for market turmoil. financial. Giorgia Meloni said in her first parliamentary speech as Italy’s prime minister that tightening monetary policy was “considered by many a reckless choice” that “creates new difficulties” for heavily indebted member states like Italy.

A key decision awaiting the ECB this week is how to reduce the attractiveness of the 2.1 billion euros in super-cheap loans it made to commercial lenders after the pandemic hit, known as targeted longer-term refinancing operations (TLTROs).

This scheme allowed banks to lend during the pandemic. But now that the ECB is raising rates above zero, it will allow lenders to make an estimated €28 billion in risk-free profits by simply placing the money they borrowed on deposit with it. of the American bank Morgan Stanley.

Such a taxpayer-funded boost for banks is politically unpalatable when households and businesses grapple with rising borrowing costs. An ECB survey of lenders released on Tuesday showed eurozone banks becoming much pickier about lending, moving away from providing mortgages at the fastest pace since the 2008 financial crisis.

One option is to retrospectively change loan terms, but banks have warned this could trigger legal challenges and increase risk premiums in some countries. Another is to change the rules for remunerating reserves, paying no interest on TLTRO borrowings. Analysts expect any changes to trigger the early repayment of around €1 billion in TLTRO loans in December. The ECB declined to comment.

The central bank could also signal that it is preparing to reduce the 5 billion euro bond portfolio it has amassed over the past decade.

Line graph of total Eurosystem assets/liabilities (in billions of euros) showing that the ECB's balance sheet has ballooned

Reducing the amount of maturing securities it replaces from early next year – a process known as quantitative tightening – would bring the ECB closer to the US Federal Reserve and the Bank of England. But economists warn that the reduction in the stock of bonds risks worsening the turbulence.

A sell-off in UK bond markets forced the BoE to intervene last month by temporarily relaunching its bond buying just weeks before it plans to start selling the large portfolio of gilts it already holds.

Frederik Ducrozet, head of macro research at Pictet Wealth Management, said the UK sell-off was “a useful reminder that any aggressive withdrawal of liquidity is likely to be very disruptive to the bond market and the transmission of monetary policy. “.

Given the scars left by the eurozone sovereign debt crisis a decade ago, when skyrocketing borrowing costs for governments in southern Europe brought the eurozone to the brink of the collapse, the ECB intends to exercise caution.

French Central Bank Governor François Villeroy de Galhau advocated a cautious approach when he told the Financial Times last week: “Balance sheet normalization should not be completely on autopilot: let’s start clearly but cautiously, then gradually speed up.

Line chart of 10-year general government yields (%) showing government borrowing costs jumped across Europe

The ECB has bought more than 2 billion euros in bonds over the past two years, accumulating more than all the additional debt issued by euro zone governments during this period. It did not stop expanding its bond portfolio until July and continues to buy around 50 billion euros of securities per month to replace those that are maturing.

Villeroy said he envisions the ECB deciding on plans to halt reinvestments in its largest bond pool – the €3.26 billion asset purchase portfolio – as early as December, with a view to putting implement the change in the first half of next year.

The central bank is expected to continue to reinvest a separate €1.7 billion Pandemic Emergency Purchase (PEPP) portfolio until 2025 at the earliest. The ECB can concentrate PEPP reinvestments in certain countries, providing a first line of defense against any sell-off in the bond markets of heavily indebted countries.

By building up such a large portfolio of government bonds, the ECB has created a shortage of highly rated securities, such as German Bunds, which is driving down risk-free rates at a time when the ECB is trying to raise them.

Konstantin Veit, portfolio manager at Pimco, said: “As there are few safe options to invest in, this leads to a scarcity of collateral and pushes much of the money market to trade well below the deposit rate. of the ECB.”

Germany’s debt agency this month sought to address that problem by creating more bonds that it can lend to investors via repo markets.