Global Markets' Biggest Question: What Will ECB Tapering Look Like? -- Update

By Jon Sindreu Features Dow Jones Newswires

Investors are dumping government bonds, certain that the European Central Bank will soon start dialing back the massive stimulus that has buoyed markets.

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They are less sure what that tapering will look like -- a key question as the ECB becomes the main focus for spooked investors around the world.

Many market participants are betting that officials will reduce bond purchases from EUR60 billion ($69 billion) to EUR40 billion during the first half of next year and then cut them to EUR20 billion in the second. But there are other options investors are considering, from tapering less to following the Federal Reserve's model of reducing the buying on a monthly basis.

Whatever the ECB does, investors expect volatility along the way.

In the wake of the financial crisis central banks cut interest rates to record lows and bought billions of dollars of assets, pushing up bond prices and sending investors chasing returns into equity and emerging markets.

Because such monetary policy was so experimental in implementation, there is little precedent in what to expect in the retreat.

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"When we are in the territory of unconventional monetary policy, expectations of what the central bank will do in the future have no anchor," said Willem Verhagen, a senior economist at NN Investment Partners, which has about EUR200 billion under management.

ECB President Mario Draghi kicked off the bond selloff last week with bullish comments about the eurozone economy that investors saw as heralding tighter monetary policy.

Yields on 10-year German bonds, which move opposite to prices, closed at 0.568% on Friday, the highest in 18 months, compared with 0.247% the day before Mr. Draghi's speech. Treasury 10-year yields traded at 2.388% from 2.143%. The euro has gained more than 2% over this period.

Yet markets were broadly unchanged by Fed minutes on Wednesday, which showed no clear consensus on how the central bank should unwind a portfolio of bonds that has been unchanged since 2014.

Most investors expect the ECB to announce the future of its bond buying as soon as September.

Aside from recent selling, another clue to what investors expect lies in derivatives markets that currently predict the ECB's first interest rate rise will be in December next year. The ECB has said it would only raise rates, currently at minus 0.4%, once it has stopped buying bonds, suggesting that investors believe that time will be before next December.

Buying less than EUR40 billion worth of bonds a month would be seen as a tightening of policy, said Thomas Page-Lecuyer, a strategist at CPR Asset Management, leading to a larger selloff in eurozone bonds and a further rally in the euro.

There are other alternatives. The ECB could also follow in the Fed's footsteps and announce that purchases will be smaller each successive month, reaching zero at the end of the year. That would likely boost bonds and depress the currency, investors say.

"If they were to give a clear date for the end of purchases, that would be a hawkish surprise for us and many in the market," said Iain Stealey, a fund manager at J.P. Morgan Asset Management.

Many investors think this is unlikely, however, because ECB officials will want flexibility. They see the Fed as a cautionary tale, after it triggered a big bond selloff when announcing in 2013 that it would taper asset purchases.

"The experience in the U.S. was very painful, and that's what the ECB wants to avoid," said Franck Dixmier, global head of fixed income at Allianz Global Investors, which has EUR480 billion assets under management.

Still, the ECB's ability to be flexible is limited by the fact that it may run out of bonds to buy in key markets. It is already undershooting the target for German debt, official data shows.

Commerzbank AG said at a rate of EUR40 billion a month, the ECB could keep buying bonds until mid-2019.

Some see another factor hurrying the ECB to the exit sign -- the eurozone's increasingly robust economy.

Analysts see the eurozone economy expanding 1.8% this year and the unemployment rate close to 9%, its lowest since early 2009. So why would Mr. Draghi keep stimulating an economy that was already motoring ahead?

But even that is up for debate. Growth may be increasing but inflation isn't. In June, prices rose 1.3% from a year earlier, far from the ECB's target of close but below 2%.

Should the ECB start tapering its bond buying next year, don't necessarily expect a sudden fall in bond prices. The central bank has no plans of selling back any of the roughly EUR2.3 trillion worth of assets it will have bought by that point. There are also other buyers out there. Pension funds and insurers are still desperate for places to put their money that offers stable income.

"While we think markets are enthusiastic in their expectations for policy normalization, we should not forget recent market movements," said Andrew Bosomworth, head of portfolio management in Germany for Pacific Investment Management Co. "New Normal bond yields are therefore likely to prevail."

Write to Jon Sindreu at jon.sindreu@wsj.com

(END) Dow Jones Newswires

July 07, 2017 12:14 ET (16:14 GMT)