In a policy meeting today, the European Central Bank (ECB) decided to extend its quantitative easing program until September 2018.
The central bank will also continue buying bonds, albeit at a slower rate. Bond buying will continue at a rate of 30 billion euors ($34.9 billion) per month, down from 60 billion euros previously.
The central bank said interest rates will remain unchanged and will continue to hover at current levels. Despite continued quantitative easing, inflation remains around 1.5%. While measures of underlying inflation have increased slightly, they have yet to show convincing signs of a sustained upward trend. The euro and yields slipped while European stocks trended upward after the ECB announced its decision to keep quantitative easing alive.
The ECB’s policy moves have been diverging from the Federal Reserve lately. The Fed plans to increase interest rates to 3% by 2019 while the ECB wants to maintain low rates in the eurozone. The Fed is also starting a gradual taper of its balance sheet, whereas the ECB continues to buy assets. Regardless, inflation remains persistently low on both fronts despite the recent disconnect in the policies of both central banks.
Don’t confuse the slowdown in bond buying with balance sheet tapering
It is important to note balance sheet tapering is different from tapering the amount of bond buying. The former can have a higher effect on stock markets. In case of reduction of bond buying, the amount of cumulative funds will continue to increase in the economy while balance sheet tapering will have an opposite effect. Therefore, it is important to differentiate between balance sheet tapering and a reduction in bond buying.
The ECB has made it clear it does not plan to initiate a balance sheet taper. Although the bank has decided to taper the rate at which the bond buying will continue, the ECB will still accumulate assets on its balance sheet. Note that tapering refers to the reduction of financial assets on the balance sheet, not to the declining rate of bond buying. The ECB notes:
“Eurosystem will reinvest the principal payments from maturing securities purchased under the APP for an extended period of time after the end of its net asset purchases, and in any case for as long as necessary.”
Put simply, the ECB has no plans to reduce its balance sheet even after the end of its asset purchasing program. Reinvesting in maturing securities will keep the balance sheet inflated, meaning no balance sheet tapering.
Source: ECB
Source: FRED Economic Data *Focus Equity’s Projection
The charts depict that while the rate of bond buying is slowing down, assets on the balance sheet are still increasing.
No tapering in balance sheet means higher stock markets
Bond buying will keep yields low while the stock market remains inflated. There has been no real effect on inflation amid easing policies. ECB President Mario Draghi commented:
“Domestic price pressures are still muted overall and the economic outlook and path for inflation remains conditional on continued support from monetary easing.”
Despite economic growth and an improvement in private sector loans, the ECB is reluctant to taper its balance sheet. Reversal, or tapering, can result in a stock market correction, which can turn into a recession. This appears to be the reason for the central bank's continuing monetary easing. The point is monetary easing is the new norm, so stock markets will continue to trend higher unless the ECB starts to taper. The Euro Stoxx 50 and DAX are already up 0.86% and 0.77% on the bank's policy news.
Takeaways
Continuing asset purchasing will boost the eurozone's economy. The euro-dollar exchange rate can decline amid disconnect in the policies of the ECB and the Fed. As the ECB keeps growing its balance sheet, European stocks will continue to move higher. It is not that straightforward for U.S. equities, however. Increasing rates and balance sheet tapering can take a toll on the U.S stock market.
Disclosure: I have no positions in any stocks mentioned and have no plans to initiate any positions within the next 72 hours.
