Dusk of Unconventional Monetary Policies for the Fed & the ECB

Why Quantitative Easing (QE)?

When the Fed and the ECB started buying bonds in the market (since 2009 and 2015 respectively), they aimed to decrease longer-term interest rates, easing the financing conditions within the economy. This was a breath of fresh air for the markets, where people could invest and spend more. The common end goal of the central banks was to avoid deflation, as well as increase inflation to their respective mandated levels. As a result, the central bank balance sheets grew over the years, as shown on Figure 1. This growth caused the net supply of bonds – available to other market participants – to shrink. With specific investor preferences for certain bonds, bond prices were bid up, which pushed the yields lower. The impact on prices of central bank buying was stronger in markets with supply limitations. The central bank induced scarcity of German government bonds is a valid example to this framework.

Central Bank's Balance Sheet Growth
Figure 1: Bloomberg, August 2017

Reactions in the Market

According to research conducted by Kempen, the initial QE announcements of the Fed led to the expected result of decreasing rates, with the yields of 10-year Treasuries dropping as much as 75 basis points in total with the first round of QE and its extension announcement, around the announcement dates. The reactions were dampened for the subsequent QE announcements of the Fed, as well as of the ECB [1]. The Asset Purchase Program (APP) announcement of the ECB, only led to a drop in yields of 10-year Bunds by 14 basis points [2], within the vicinity the announcement date. This implies that now being aware of the consequences, markets can price such announcements better, without panic and exaggeration. When this is taken into account along with the Fed leading the balance sheet contraction, it is likely that ECB’s tapering/reinvestment announcements will have smaller reactions in the market.

And Then?

Looking at a longer time-horizon, we gaze at a different landscape. Fed’s balance sheet expansion does not appear to be correlated with the change in Treasury yields. Surprisingly, the story is different for the ECB. Below, Figure 2 displays the relationship between central bank assets and their corresponding government yields (inverted), on a year-on-year change basis. This suggests that the inflation expectations were dominant in the Treasury market, as the market participants perhaps believed that the purchases will actually increase inflation, hence the yields. On the other side, a supply shock effect was observed in the German government bond market, where yields decreased as ECB initially expanded its balance sheet.

YoY Change in Central Bank Assets vs. Their Respective Government Bond Yields
Figure 2: Bloomberg, August 2017

The regressions modeled by Kempen, which examine the explanatory variables for the change in yields, does not display statistical significance for Fed’s balance sheet expansion. On the other hand, in line with Figure 1, ECB’s balance sheet expansion by €1 trillion corresponds to a decrease in 10-year German Bunds by 81 basis points over a year. This relation, however, appears to be decoupled over the last year, where yields have increased as the ECB continued its expansion.

ECB’s Tapering

We expect that the balance sheet expansion will slow down, as ECB is expected to announce its tapering schedule in their meeting in October. Comparing the level of potential purchases with the current €60 billion purchases per month, we have the following scene in Figure 3. This suggests that if the purchases drop to €20 billion per month, then there will be 20 basis points upward pressure on 10-year German Bunds by June 2018, according to Kempen calculations. Given the 33% issuer limit it faces, ECB will be forced into tapering, unless they remove the limit, which is unlikely to happen.

Difference in Yields
Figure 3: Kempen Capital Management, September 2017

The Reinvestment Schedule

Coinciding with its tapering in our view, ECB will have to increase its reinvestments in the next year to maintain its balance sheet composition, at a level of €10 to €15 billion purchases per month. This might mitigate the effects of tapering, as the total purchases will be closer to €60 billion per month with the addition of reinvestments.

When evaluating reinvestments, it is necessary to see where the ECB stands today. Figure 4 displays the composition of the Public Sector Purchase Program (PSPP) portfolio, beside the German government bond purchases, with their corresponding weighted average maturity. Given that the German bonds make around 24% of total composition, and also as the weighted average maturity decreased since the beginning of this year, it is likely that the reinvestments will predominantly include German bonds at the shorter end of the yield curve. 

German Bund Purchases
Figure 4: Bloomberg, ECB August 2017

Reverse Effects from Contraction?

Unlike the expansion phase, where central banks outright purchased bonds from the market, during the contraction phase, these assets will not be sold directly; instead the central banks will hold them until they mature. Therefore, we will not see the direct opposite (expansionary) supply shock in the market. 

Talking of supply, one should keep an eye on the net issuance levels of government bonds. If there is no longer demand for government bonds from the QE programs, then the net issuance levels should increase. We expect that this would increase the yields as a result, due to an increasing supply. However, given that the governments do not face pressure to increase their deficits as they did during the financial crisis, the issuance levels might not rise, which would negate the effects from the withdrawal of QE.

Dusk, but not Darkness

Looking forward, one might think that the transition into conventional monetary policy leads us to a dark path; yet another unchartered territory. But now, we have fewer reasons to fear, as we have the torch of transparency and predictability to guide us along the way.


[1] This is in line with Ehlers and Sushko (2012), who found that “announcement effects of asset purchase programmes have waned”, over the years.

[2] Compare to Altavilla et al. (2015), who found a decrease in 10-year German Bund yields by 17 basis points, around APP announcements.


This document of Kempen Capital Management N.V.(Kempen) is for information purposes to professional investors only. The information in this document is incomplete without the verbal explanation given by an employee of Kempen Capital Management. The opinions expressed are Kempen’s opinions and views as of such date only. 


The Asset Allocation  Desk

Marius Bakker
Ivo Kuiper
Joost van Leenders


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