07.07.2017 — CHART OF THE WEEK - Taper tantrum No. 2: how much do we have to worry?

  • Bond markets are taking fright: The US Fed looks set to start shrinking its balance sheet gradually this autumn, the ECB is celebrating an acceleration of Eurozone growth beyond its trend rate, the BoE will probably react to its current inflation overshoot by raising rates no later than this November and some smaller central banks are also adjusting their stance: bond investors fear that the fundamentals are shifting against them. Do economists have to worry as well?
  • Remember the taper tantrum: We’ve seen this before. After then-Fed chairman Ben Bernanke told a Congressional committee on 22 May 2013 that the US Fed would start to reduce its asset purchases eventually, bond yields spiked and equity markets worried that a less aggressive monetary stance would hurt the economy and profits. What happened next? US economic growth accelerated in the two quarters after the Bernanke testimony, inflation did not. Although 10-year Treasury yields rose from 2% in mid-May 2013 to 3% by the end of the year, they fell back to 1.8% in January 2015.
  • Getting Sintra wrong: ECB president Mario Draghi triggered taper tantrum No. 2 when he explained on 27 June why the ECB expects core inflation to edge up gradually over time in response to robust GDP growth. Markets took that as hawkish. But that missed the major point: at Sintra, Draghi simply presented the basis for the current ECB projections. He did not change these projections and hence the basis for the ECB’s policy outlook. As before, we expect the ECB to phase out its asset purchases gradually from January 2018 onwards and raise its refi rate for the first time in Q3 2019.
  • No need to worry too much: Market concerns that the ECB may scale back its stimulus too early should be largely self-correcting. If any resulting rise in bond yields or the exchange rate would be grave enough to potentially impair the outlook for growth and inflation, the ECB would simply maintain its full monetary stimulus for longer. The ECB will do all it can to keep the economic recovery and hence the outlook for employment as well as corporate profits on track.
  • Central banks matter – but they are not the sole masters of the bond universe: Bond yields are still very low. The long-term direction is up. But amid the usual volatility, this process should remain gradual. Real interest rates balance the supply of savings with the demand for investible funds on global capital markets. We expect neither an abrupt collapse in global savings nor a sudden spike in investment that would justify a major and sustained surge in real yields. As inflationary pressures are creeping up only very slowly, the scope for a sustained spike in nominal bond yields remains limited. Shifting market perceptions of central bank intentions merely add some volatility to this process.
  • Mind the core: The one accident which could force the ECB to scale back its stimulus fast, namely an abrupt sustained surge in core inflation, does not seem to be on the cards. In the last three months, Eurozone core inflation has hovered around 1%, close to the 0.9% average of the previous three years. Over the last six years, core inflation has usually come in lower than the ECB had projected. If in doubt, the ECB will follow the US Fed and err on the side of caution, reducing its stimulus only when the data clearly point that way. Goldilocks can stay in the Eurozone for years to come.