During his eight years at the helm of the European Central Bank, Mario Draghi has earned a reputation for getting his way. As he lines up a fresh salvo of monetary stimulus next week, investors are betting heavily that the Italian can corral any reluctant colleagues one last time.
Government bonds in the eurozone have staged an unprecedented summer rally, with yields sinking to record lows across the currency bloc. Even after a global sell-off on Thursday on hopes of a breakthrough in US-China trade talks, all maturities of German debt trade at negative yields, meaning investors are paying Berlin to borrow for up to 30 years.
Investors have piled into bonds in part because they expect a revival of the ECB’s bond-buying “quantitative easing” programme. And they expect the fresh round of QE to be big.
“Draghi is going to have to go into proper Buzz Lightyear mode,” said Richard Barwell, head of macro research at BNP Paribas Asset Management, evoking the Toy Story character. “‘QE infinity and beyond’ is what the market wants. I think people have bought these bonds because they expect to be able to sell them to the central bank.”
Expectations have ramped up despite many of Mr Draghi’s ECB colleagues expressing scepticism about the need for more QE in recent days. The doubters include the usual suspects like the Dutch and German central bank governors, who frequently opposed the ECB’s previous €2.6tn debt buying programme, which ended last December. But France’s François Villeroy de Galhau, not a known hawk, raised eyebrows last week when he described further bond purchases as “a question to be discussed”.
Mr Draghi may be forced to compromise, either by launching a small, time-limited programme of bond-buying at Thursday’s meeting, or by leaving further QE as a decision for his successor Christine Lagarde. That could be a nasty shock for investors.
“It’ll look like they clipped his wings,” Mr Barwell said. “You could see a market tantrum once the significance of that sinks in.”
In addition to an interest rate cut of at least 0.1 percentage point — which would take the ECB’s deposit rate to minus 0.5 per cent — markets are pricing in €40bn a month of bond purchases, according to Stefano Di Domizio of Absolute Strategy Research.
To achieve that rate of bond-buying for more than a few months, the ECB would probably have to rewrite its own rules about how much of the bond market it is prepared to buy. Currently, it cannot own more than a third of any country’s bonds but is running close to limits in Germany, Finland and Portugal.
Raising the limit to 40 or even 50 per cent would ease those bottlenecks but would also be controversial, handing the ECB an ever more pivotal role if a eurozone nation were to default on its debt and needed to negotiate with creditors over a restructuring.
A smaller QE programme — of around €20bn of purchases for six months — might allow the ECB to duck the topic but could leave markets doubting its commitment to further stimulus.
“There’s a clear risk that there could be disappointment,” said Seema Shah, chief strategist at Principal Global Investors. “If there’s no discussion or mention of the issuer limits, the market will take that very negatively.”
Still, many investors expect any setback to be shortlived, arguing that the bond rally reflects profound worries over global growth over and above expectations of ECB debt purchases.
“The price action has been so strong that at some point we will see a bit of a bond shock,” said Chris Iggo, chief investment officer for fixed income at AXA Investment Managers. “I’m not sure anything the ECB can do can reverse the trend in bond markets for long. It’s down to deep-rooted structural factors like demographics and the legacy of the financial crisis.”
With or without enhanced QE, many investors are happy to hold on to negative-yielding bonds on the basis that a rebound in growth or annual inflation, which now stands at 1 per cent, looks distant. “The state of the economy certainly suggests rates are staying negative for a very long time,” said Ms Shah.
This ambivalence towards the bond-buying programme is one sign of a growing lack of faith in monetary policy as a solution to the global growth malaise — both in markets and inside central banks themselves. The Bank of Canada, the Reserve Bank of Australia, and Sweden’s Riksbank have all pushed back against investors’ expectations of more stimulus over the past week.
In the eurozone, policymakers are increasingly concerned that cutting interest rates further below zero could do more harm than good, by hitting banks’ profit margins or even by encouraging investors to stash banknotes in a vault rather than submit to negative rates.
Bond markets’ bet on more QE is also a bet on the policy’s ultimate failure to drag up inflation. “Central banks are still saying they are trying to achieve 2 per cent inflation,” said Mr Iggo. “But the market’s given up on thinking they are going to have much success.”