Central Banks are finally getting into the swing of quantitative tightening (qt). The Bank of Canada has shed a fifth of its balance-sheet this year. The Bank of England held its first gilt auction on November 1st. The Federal Reserve’s balance-sheet shrank by $85bn in October, twice the size of the reduction three months earlier. But in Europe, where officials have flirted with qt for months, the European Central Bank (ecb) is yet to let go of a single bond.
The continent’s central bankers have sent mixed messages about when qt will arrive. In September Christine Lagarde, the ecb’s president, said details would be provided after the bank finished raising interest rates. At a meeting on October 27th the ecb promised to lay out “key principles” in December. Five days later, Joachim Nagel of the Bundesbank said that Germany expected qt in early 2023. Pablo Hernando de Cos of Spain’s central bank sharply retorted that a longer wait was required.
qt is a nerve-racking experience for all central bankers. When buying bonds during quantitative easing (qe), policymakers were unsure about the impact of their growing balance-sheets. In reverse, the uncertainty is greater, particularly given the fragility of financial markets and the global economy. Experiments with qt have gone wrong in the past, as in 2019 when the Fed roiled the Treasury market.
And qt is particularly difficult for the ecb. Most central banks have bought just one government’s debt. The ecb has 19 bond markets to worry about. One effect of qe is that it reduces the spread between the low borrowing costs of Germany and those of indebted economies like Italy. When inflation was low the ecb could pass this off as a side-effect of its stimulus. Now it is raising rates it must find other arguments in favour of containing spreads.
In parts of Europe’s financial system, qt looks increasingly urgent. The continent’s financial firms borrow and lend €11.5trn ($12trn) every year in its “repo” markets, in which the firms post bonds as collateral in return for short-term funding. The market is so big in part because policymakers encouraged its growth in the early days of the euro zone, hoping that German and Greek bonds would change hands on the same terms. This dream of a uniform repo market died during Europe’s debt crisis a decade ago, when companies thought Irish and Portuguese bonds were so risky that they stopped swapping them altogether, ultimately widening spreads. But it has left legions of lightly regulated traders ravenous for German bunds.
Since 2015 the ecb has scooped up bonds, starving these traders of collateral. Recent rate rises have worsened the shortage. Higher rates push down bond prices. Because it is the value of bonds which matters when posting collateral, a given transaction now requires more bonds. The higher rates go, the worse the problem.
German bonds have become so scarce that traders betting on yields have bid up their price. In September yields on some short-term bonds, half of which are on the ecb’s balance-sheet, fell 1.1 percentage points below interbank interest rates, to their lowest since the euro-zone crisis. Though high rates in Italy might mess with monetary policy, cheap borrowing in Germany could undermine the inflation fight.
The ecb’s policymakers are thus caught in something of a bind. Rapid qt would release short-term German bunds from its balance-sheet, ease Europe’s shortage of collateral and placate inflation hawks. But it would also threaten to widen spreads on long-term debt that—in a nightmare scenario like the euro-zone crisis—could be pushed still wider by traders turned off by risky peripheral collateral. Delaying qt protects the periphery. It does so at the cost of raising the financial stakes. ■
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