How Can The ECB Avoid A Taper Tantrum

The ECB’s next steps are critical for the path of global bond yields. Our strategists highlight 5 possible paths the ECB’s policy could take.


  1. The ECB ends their QE program in March 2017, as currently planned;
  2. The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month;
  3. The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month;
  4. The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month;
  5. The ECB extends QE to March 2018, but cuts to €60bn per month.

The bottom panel shows that the growth rate of the ECB’s monetary base will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of bond yields have been broadly correlated with the growth rate of the monetary base.

Bottom Line: In order to avoid a taper tantrum the ECB must extend its QE program by signaling to the markets that the ECB wishes to maintain low interest rates for longer. The next Insight looks into how the ECB can extend its QE program.

The ECB’s Dilemma

At today’s zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system and the economy.


Rock bottom interest rates have clearly hurt net interest margins. Whilst bank can respond by cutting deposit rates, once the policy rate hits zero, this profit-protection strategy hits a wall. A negative deposit rate would risk an exodus of out of bank deposits into cash or cash-substitutes. A deposit flight could create a liquidity crisis, forcing banks to shrink their balance sheets. Alternatively, banks could charge a higher rate to borrowers, but this would tighten credit conditions. Therefore, banks are left to take a hit to their already thin net lending margins. This also tightens credit conditions because pressure on profitability and share prices increase the cost of equity, making it harder to raise capital. Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions.

Bottom Line: The paradox is that at the zero bound, the smallest additional monetary loosening – via interest rate cuts or QE – risks stalling euro area bank credit creation. It thereby risks stalling economic growth.

EM Reflation Confirming Indicator Raises A Red Flag

With their Reflation Confirming Indicator rolling over, our EM strategists believe that it is only a matter of time until EM equities follow.


The Reflation Confirming Indicator is an equally weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation). A downturn in this indicator suggests that global reflation may subside and that demand for commodities could follow soon after. Falling commodity prices will spell trouble for EM economies and risk assets.

EM equities decoupled from our Reflation Confirmation Indicator in early 2015. Ultimately, the gap was closed by EM equities breaking lower. Continued weakness in our reflation gauge will indicate downside risks for EM assets.

European Banks: Three Headwinds

BRRD, NPLs and NIRP are three long-term headwinds for European bank investors.


The EU’s Bank Recovery and Resolution Directive (BRRD) came into force on January 1. This sets out a framework for resolving a troubled or failing bank. The good news is that an individual bank failure, however large, should not constitute a systemic risk. The BRRD forces the ECB, the Eurosystem and governments to prioritize the protection of payment systems, taxpayers and depositors. The bad news for investors is that “other parts may be allowed to fail in the normal way” – meaning the allocation of losses will follow the usual ranking: equity, subordinated debt, senior debt.

Another concern for investors is the size of the non-performing loans (NPLs). These equal 30% of bank equity in Spain and 100% of bank equity in Italy. Rapidly disposing of the NPLs at fire sale prices would be counterproductive as it destroys capital. Meanwhile, the BRRD prevents governments from recapitalizing the banks until investors have first suffered substantial losses. It follows that only with a crisis will the NPL problem be solved quickly; without a crisis, it will be solved very slowly.

Adding insult to injury is the ECB’s misguided negative interest rate policy (NIRP). At the zero bound, lower interest rates do very little to boost lending volumes. Rather, they compress already wafer-thin net lending margins. This pressure on bank profitability and share prices pushes up the cost of capital. And given that a major constraint to new lending is a shortage of capital, NIRP paradoxically tightens monetary conditions.

The next Insight discusses the broad implications of weak banks for investing in European equities.

Tactically Cautious On Global Equities

A December Fed rate hike, uncertainty regarding the U.S. presidential elections, weak earnings growth, diminished buyback activity and concerns about European banks pose near-term risks to global equities.


The summer rally has left equity valuations looking stretched. The median U.S. stock now trades at a higher P/E ratio than even at the 2000 peak. The Shiller P/E ratio stands at 27, but would be 37 if profit margins over the preceding ten years had been what they were in the 1990s. The fact that interest rates are low gives stocks some support, but with the Fed likely to hike rates in December, that tailwind will begin to fade.

Lackluster earnings growth remains another concern. S&P 500 and economy-wide profit margins have rolled over. Granted, the collapse in profits in the energy sector has been the major culprit, and this headwind should wane if oil prices edge higher over the next 12 months, as we expect. Nevertheless, faster wage growth and a firm U.S. dollar will limit any recovery in margins. A Trump victory could also trigger a trade war, while a Clinton triumph could mean higher taxes and increased regulatory burdens. Both will be headwinds for the corporate sector.

Bottom Line: Our Global Investment Strategy service believes global equities are vulnerable to a near-term correction.