By Christopher Whittall
Bond investors are betting further stimulus from the European
Central Bank is a done deal, leaving markets vulnerable to a swift
pullback if the bank disappoints at its policy meeting
Thursday.
Riskier European debt has rallied this week despite Italy's "no"
vote in a referendum on constitutional reform, the result of which
has the potential to destabilize the eurozone. Italian debt also
bounced back from a selloff on Monday.
Analysts say those moves, and others, reflect market
expectations that the ECB will on Thursday extend its EUR1.7
trillion ($1.82 trillion) bond-buying program by at least six
months until September.
Some central banks have bought bonds massively to lower
borrowing costs and stoke inflation, and their actions and
anticipation of them continue to exert an outsized impact on
markets.
The ECB has a recent history of disappointing investors
expecting more stimulus. The central bank's current appetite to
extend its historic ultra-loose monetary policy may have been
blunted by a recent round of encouraging economic data in the
eurozone. The muted market reaction to the Italian vote could
suggest ECB support is encouraging investors to ignore risks.
"What's priced into markets is a fully fledged extension of the
program, " said Isabelle Mateos y Lago, chief multi-asset
strategist at BlackRock Inc. But "we think there's a significant
chance the ECB disappoints markets," Ms. Mateos y Lago said.
That could lead to a sell-off in the riskier government debt of
Europe's so-called periphery made up of the weaker mainly southern
economies, and even France, whose bonds have fallen ahead of the
country's presidential election next year, she said.
The ECB has become one of the European bond market's biggest
investors and investors have become used to their buying buoying
prices.
In March, the bank raised its monthly asset purchases by EUR20
billion to EUR80 billion. In June, it added corporate bonds to its
shopping list alongside government debt and more structured
securities such as repackaged mortgages it buys under other
purchase programs. The corporate bond buying saw companies'
borrowing costs fall to historic lows as the market rallied
sharply.
Equally, markets can tumble when the ECB disappoints.
Last December, the euro jumped more than four cents against the
dollar, stocks tumbled and the price of riskier bonds fell after
the bank delivered a smaller-than-expected package of stimulus
measures.
ECB officials have said that they are sensitive to the risks
that they could trigger overblown market expectations about future
monetary policy.
"I would hate to come into work to see what would happen" if the
ECB announced an end to its program, said Edward Farley, head of
European corporate debt at PGIM Fixed Income.
With the bond-buying program scheduled to end in March, the ECB
is running out of time to inform investors of its plans. Even as
investors expect more stimulus on Thursday, the debate with some
analysts is moving to whether the ECB could start tapering its
stimulus program in March.
Like other investors, Mr. Farley expects a six-month extension
to the ECB's asset purchases. Still, he says he has been avoiding
securities like southern European corporate bonds that look most
vulnerable "if there is any accident with central bank policy."
There is little sign investors expect that on Thursday.
Peripheral government bonds and corporate debt has rallied this
week despite the "no" vote in Italy's referendum which outgoing
Prime Minister Matteo Renzi had presented as a way to revitalize
Italy's stuttering economy.
Investors seemed unfazed by Mr. Renzi's resignation after the
vote even though it could bolster the fortunes of the populist
5-Star Movement which has called for a non-binding referendum on
Italy's membership of the euro.
The gap between 10-year Italian and German bond yields has
narrowed by around 0.07 percentage point this week to around 1.56
percentage points, according to Tradeweb. Media reports that the
Italian government was ready to take a controlling stake in
troubled lender Banca Monte dei Paschi di Siena seemed also to fuel
the rally.
The spread to Germany, the bloc's largest economy, also narrowed
for Portuguese, Spanish and French bonds. The annual cost of
insuring against a default protection on $10 million of European
high-grade debt for five years using credit default swaps has
dropped by around $4,000 to $74,000 this week, according to IHS
Markit.
Economists highlight good reasons for the ECB to keep buying
bonds. The central bank has an inflation target of close to 2% but
consumer prices in the Eurozone were only 0.6% higher in November
than the same month last year.
Others argue further stimulus isn't warranted. The eurozone's
economic picture is brighter, with business activity growing at its
fastest pace this year in November, according to a survey of
manufacturers and service providers.
The market's subdued reaction to the Italian referendum may show
that investors have become too reliant on the central bank to
smooth over the eurozone's probelms, a factor that may concern some
ECB officials.
"I don't think that [argument] will win the day, but it's a
risk," said Stefan Isaacs, deputy head of retail fixed income at
M&G Investments. It would be "dangerous" for the ECB to pull
back before it has succeeded in boosting inflation, Mr. Isaacs
said.
--Tom Fairless contributed to this article.
Write to Christopher Whittall at
christopher.whittall@wsj.com
(END) Dow Jones Newswires
December 07, 2016 12:12 ET (17:12 GMT)
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