ECB Considered Dropping a QE Guarantee at June Meeting -- 3rd Update

German government bond yields hit their highest level in 18 months on Thursday as new evidence indicates the European Central Bank is preparing to step back from eurozone debt markets.

Financial markets have been jittery in recent days as investors focused on whether the ECB might soon wind down its giant bond-buying program, known as quantitative easing, or QE, as the region's economy accelerates. The EUR60 billion-a-month program has bolstered asset prices and pinned down interest rates across the 19-nation eurozone since it was launched more than two years ago.

The ECB took a tiny step toward reducing its massive stimulus at its June policy meeting, signaling its increased confidence in the region's economic recovery and indicating it was unlikely to cut interest rates again.

The minutes of the June meeting, published Thursday, show policy makers considered going even further by dropping a pledge to accelerate QE if the economic outlook darkens. Removing the pledge would be a final step toward scaling back the program.

The euro rose more than a quarter-cent against the dollar to $1.14 after the minutes were published. Germany's 10-year government-bond yield rose to 0.57%, the highest level since January 2016.

Analysts said the ECB is inching toward tapering QE, a move that is expected to have a far-reaching impact on eurozone asset prices and interest rates.

"It's evolution, not revolution, but the direction of travel is clear," said Ken Wattret, an economist with TS Lombard in London.

The ECB's large-scale purchases have increased the demand for eurozone government bonds, boosting their prices and reducing their yields, or the return paid for holding them. As the ECB is expected to buy fewer bonds, the demand for them will fall and their yields will rise. Investors have already started to price that in.

ECB President Mario Draghi rocked financial markets last week by suggesting that the central bank might ignore temporarily weak inflation data and start reducing its stimulus as the economic recovery gains traction.

The economy in the 19-nation bloc has expanded for 16 straight quarters and its unemployment rate has fallen to an eight-year low of 9.3%. Consumer and business sentiment indicators are flashing green.

Some ECB officials have pounced on Mr. Draghi's message to call for a prompt end to QE bond-buying. Speaking in Vienna on Thursday, German central-bank governor Jens Weidmann argued that the eurozone's economic recovery "opens the possibility for a normalization of monetary policy."

"It's not about slamming on the brake...but about taking one's foot off the gas a bit," Mr. Weidmann said.

Still, other policy makers have urged caution. Despite stronger growth, the eurozone's inflation rate fell to 1.3% last month, short of the ECB's target of just below 2%. The bank's chief economist, Peter Praet, warned twice this week that it must push on with its monetary stimulus until the job is done.

"Our mission is not yet accomplished. We need patience and persistence," he said in Paris on Thursday.

Many ECB officials worry that a sudden policy move might trigger a sharp rise in borrowing costs across the region, which could upset the economic recovery. Bond yields rose dramatically after the Federal Reserve signaled four years ago that it would wind down its QE program, in an episode that became known as the taper tantrum. The ECB also has a history of raising interest rates too soon.

Most economists nevertheless expect the ECB to signal in September or October that it will start winding down its bond purchases early next year. One key reason: The ECB is expected to struggle to find enough bonds to buy next year, especially in Germany, due to constraints on its exposure to individual governments.

"On balance, we still see the bank tapering its asset purchases from the current pace of EUR60 billion a month to zero by June [2018], starting in January," said Jennifer McKeown, an economist with Capital Economics in London. "But if the euro or bond yields rise significantly further in the meantime, the pace may be even slower."

--Todd Buell in Vienna contributed to this article.

Write to Tom Fairless at tom.fairless@wsj.com

(END) Dow Jones Newswires

July 06, 2017 15:03 ET (19:03 GMT)