European credit market not pricing in magnitude of QE

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Jorgen Kjaersgaard (pictured) is head of European Credit at AllianceBernstein.

It is near certain that we’ll finally see “white smoke” from the ECB on 26 October, with an announcement it’s going to accelerate its tapering program.

However, we believe the market has not fully priced in the magnitude and impact of this decision. This is worryingly clear, given the current yield level combined with the fact the European aggregate universe has seen a steady increase in overall duration–the rates market has further to fall than market participants have yet priced in.

The market is expecting in a reduction of government bond QE buying to 40 billion a month. We believe the QE will fall further — to 20 billion a month, though we’re expecting QE buying to continue for nine months from January 2018. Unless the market adjusts soon to this outcome, such a move will result in volatility as the market reprices.

The QE reduction will result in short-end rates remaining anchored while 10-year rates are likely to jump 30-40 basis points higher. The resulting steepening in the yield curve should be beneficial for banks and insurance companies whose margins expand as rates rise.

The ECB’s Corporate QE will continue at an unchanged pace in the beginning of 2018. This means European credits (both IG and HY) are likely to outperform government bonds. Credits with short to mid-term durations should perform the best and financials and cyclical sectors should outperform.

QE tapering before the inflation target has been met makes sense for the ECB as the central bank has plenty of ways to manage stimulus as we go through 2018. It is worth remembering that net purchases are still being made, reinvestments are occurring, there is scope for a possible operation twist to keep maturities long–and rate hikes are in the frame only “well after” the maturity target is dropped.

A surprise stepping down from a monthly purchase pace of €60bn to €20 billion could be a difficult pill for markets to swallow. However, the ECB is tapering its purchases because the economy no longer needs them and low inflation means that the ECB is only going to withdraw monetary accommodation gradually.

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