- The ECB kept its policy on hold Thursday to protect the nascent eurozone economic recovery from tightening global financial conditions and on the back of temporary inflation pressures, but it might make a move in September as the outlook brightens up.
- Complicating the ECB's job to keep long-term rates low are the forces at work on the eurozone government bond market, which reacts strongly to changes in global financing conditions. We find that German government 10-year bond yields react almost one to one to a rise in the world yield, and a 100 bps increase in the U.S. 10-year yield leads to a 50 bps rise for Bunds.
- That said, the ECB's quantitative easing has reduced the responsiveness of German government 10-year yields to a 100 bps rise in world and U.S. yields, by about 25 bps since 2015. This means a rise of U.S. yields by 50 bps today would lift the Bund only 15-20 bps--not out of negative territory.
- At the same time, the ECB's asset purchases are ever closer to the implicit limits set out by the EU Treaty, making it potentially harder for the ECB to shield the eurozone from further tightening of global financing conditions more difficult than before.
- Even with a 50 bps rise in the U.S. Treasury by September, Bunds would still likely be in negative territory at 0% from -0.2% currently, something the ECB could be happy to live with if economic and inflation data remains on track.
Economic risk and uncertainty have receded worldwide as vaccination rollouts are enabling a return to pre-COVID-19 living standards, contributing to the recent rise in long-term government bond yields for advanced economies. Yet, this has happened against the will of the European Central Bank, which showed Thursday that it would rather keep interest rates lower for longer, since the eurozone is lagging the global recovery cycle (see chart 1). Inflationary pressures are still of a temporary nature, mostly caused by higher energy and input prices (see chart 2), while a lot of slack in the labor market will keep a lid on wage growth for now (see "Economic Research: This Time, Europe Is Set To Stage A Jobs-Rich Recovery," March 16, 2021). However, S&P Global Ratings expects the economy to head for a strong rebound in the second half (similar to the ECB's expectations), thanks to the effects of widespread vaccination.
A more deeply rooted recovery means the ECB will very likely start tapering its Pandemic Emergency Purchase Program in September, armed with its updated forecasts. That will be much easier once the eurozone economic outlook has brightened and is better synchronized with the rest of the world.
What may make it more difficult for the ECB to keep long-term rates low are diverging trends on the global bond market. Our research finds a strong correlation between eurozone yields and those of other safe asset markets globally. This means that a fast rise in the long-term rates of other advanced economies could spill over into higher eurozone bond yields (as we show in the next section), putting pressure on the ECB to keep its QE program running at the current pace for longer to exert more downward pressure on yields (see chart 3). However, the ECB is also slowly reaching the limits of the share of outstanding government bonds it can hold on its balance sheet. Issuance of EU bonds to finance the Next Generation plan might alleviate these constraints, yet it's not clear at this stage what exact relief it will provide to QE programs (see chart 4).
If the ECB is in a position to reduce the pace of its purchases in September, it might also use that opportunity to clarify the future of its two QE programs. By design, the PEPP is more flexible than the asset purchase programme (APP) because it is not bound by capital keys weights for each country's purchases. The ECB could judge that this flexibility is no longer necessary as the economy recovers and to prepare the markets for the planned end of the PEPP by March 2022. To that aim, the ECB may seek to combine the PEPP and APP program into one, but will have to adjust volumes in a way that doesn't create a taper tantrum.
The global co-movement in long-term yields makes it more difficult for the ECB to keep long-term rates at low levels
The ECB scaled up asset purchases in March to avoid an unwarranted tightening of financing conditions, which originated from a rise in U.S. yields at the start of the year that spilled over into eurozone yields. Helene Rey (2015) shows that, as the U.S. is the issuer of the world reserve currency, its monetary policy can send shockwaves through the global financial system. To understand how this may affect the ECB's monetary policy, we investigated this relationship through the lens of bond yields. However, we widened the co-movement analysis from just U.S. yields to a set of yields in countries with safe assets (hereafter called world yield). This approach draws on the literature about the global fall of long-term interest rates, which identifies common structural trends affecting global safe assets (see chart x; Hördahl et al. 2016, Moench 2019).
To model these dynamics, we follow a similar methodology as Hördahl's (Hördahl et al. 2016). We assume that German 10-year yields react to ECB monetary policy at the short end of the curve (the Euribor three-month rate) and is driven by either:
- U.S. dynamics (proxied by the 10-year U.S. Treasury bond, or
- A common factor affecting safe assets (world yields) at the long end of the curve.
We also include a variable that measures monetary policy divergence between the U.S. and the eurozone: the difference between the shadow rates for the U.S. Federal Reserve and for the ECB. This variable could explain some of the divergence in long-term rates if the U.S. is the dominant source of spillover and control for exchange rate dynamics that are likely to influence investors' behavior when they invest in different markets.
For comparability purposes in our modeling exercise, we reconstructed a world yield based on the extracted principal component. We extracted that from a set of 10-year yields of advanced economies (AE), considered providers of safe assets. The three groups are:
- World (all AE): U.S., Japan (JP), Canada (CN), Australia (AU), New Zealand (NZ), U.K., Switzerland (SW), France (FR), and Germany (BD);
- World (non-Eurozone AE): U.S., JP, CN, AU, NZ, UK, and SW; and
- World (non-European AE): U.S., JP, CN, AU, and NZ.
Because of the strong co-movement in advanced economies' long-term yields, the first factor explains more than 90% of the variance in the data (see chart 5). Interestingly, the weights we attribute to each country through the principal component analysis are almost identical (see table 3 in the Appendix for details). This suggests there is not one single country alone driving the common safe asset factor.
Our results confirm that the ECB is constrained by the dynamics of U.S. and other safe asset markets when seeking to steer financing conditions at the long end of the eurozone yield curve. We find that Bund yields react almost one to one to a rise in the world yield--almost twice as much as U.S. 10-year yields and about 10 times more than the move induced by a rise in the eurozone short-term rate (see table 1). Interestingly, while the U.S. is the biggest provider of safe assets and therefore more likely to set global financing conditions, broader global market dynamics are also relevant. Including other safe asset providers in the world yield improves the explanatory power of our model, even when we focus only on non-European peers (see model 4 versus model 3).
The ECB has managed to reduce the responsiveness of eurozone yields to external dynamics with its large asset purchases. Using rolling regressions, we see that a 100 basis points (bps) rise in the world yield, or in the U.S. 10-year yield, is now associated with a Bund yield rise of around 65 bps and 35 bps, respectively, down from 90 bps and 60 bps prior to 2015 (see chart 6). The rolling regressions also suggest that even if the ECB reduces the pace of its purchases in September, this relationship is not likely to reverse. The ECB has accumulated so many eurozone safe assets on its balance sheet that the supply shortage is still likely to continue putting downward pressure on yields for the foreseeable future through the stock effect (Coeure 2018).
Splitting the U.S. 10-year into its neutral and term component, we see that U.S. spillovers to Bund yields have originated more from risk premiums over the past five years than monetary policy. Indeed, the rolling regressions show that spillovers from U.S. monetary policy to the eurozone (the neutral yield) are at their highest point when ECB and Fed monetary policy is synchronized (2008-2015). This is similar to findings from Moench (2019), who shows that the term component is the main driver of the co-movement of global yields. This also explains why differences in U.S. and ECB monetary policy (proxied by the shadow rate) has a very small impact on Bund yields and becomes insignificant in the models including the world yield, similar to results by other researchers (Hördahl et al. 2016).
|Determinants Of German Bund Yields|
|10-year yield BD|
|10-year yield US||0.538***|
|10-year Neutral US||0.609***|
|10-year Term Premia US||0.514***|
|EURO to 1 USD % change m/m||-1.120***||-1.131***|
|World yield (Non-Eurozone AE)||0.977***|
|Effective rate (Non-Eurozone AE) % change m/m||-1.970***|
|World yield (Non-European AE)||0.867***|
|Effective rate (Non-European AE) % change m/m||-1.771***|
|Difference in EZ and US shadow rates (ECB-FED) with lag 1||0.066***||0.073***||0.006||0.031|
|Note: *p<0.1; **p<0.05; ***p<0.01. Unless explicitly mentioned, all the variables are expressed in first differences month over month. AE: advanced economies. World yields : first principal component, rescaled in order to preserve the mean of the country variables. World yield (Non-Eurozone AE):US,AU,CN,NZ,JP,SW,UK. World yield (Non-European AE):US,AU,CN,NZ,JP. Period : 1999/2021. Source: S&P Global Ratings.|
Lower risk aversion and QE tapering are potential triggers of higher long-term world yields
As the world yield has a sizable impact on eurozone financing conditions and consequently the ECB's monetary policy, we investigated some of its potential drivers. The results (see table 2) highlight two main drivers:
- Higher risk aversion (measured by the VSTOXX International Volatility) is associated with lower yields, highlighting that demand for safe assets tends to rise in times of risk.
- The Fed and ECB's QE. Rolling regressions show that U.S. monetary policy matters for the world yield when global growth is synchronized and when the Fed is engaged in quantitative easing (such as after the global financial crisis until 2014; see chart 7). Similarly, the ECB's monetary policy has exerted growing downward pressure on world yields since the onset of its own QE program in 2015.
- Comparing the coefficients associated with the ECB and the Fed shadow rate during 2008-2014 suggests that Fed policy mattered more than the ECB's following the global financial crisis, likely because the ECB's QE program started much later when the Fed had already ended its own.
|Determinants Of The World Yield|
|World yield (All AE)|
|Volatility Index World||-0.007***|
|US shadow rate with lag 1||0.050|
|Eurozone shadow rate with lag 1||0.220***|
|Note: *p<0.1; **p<0.05; ***p<0.01. All the variables are expressed in first differences month over month. AE : advanced economies. World yields : first principal component, rescaled in order to preserve the mean of the country variables. World yield (All AE): US,AU,CN,NZ,JP,SW,UK,FR,BD. Period : 1999/2021. Source: S&P Global Ratings.|
To sum up, while today's growth and inflation prospects suggest the ECB may be able to start reducing the pace of its asset purchases from September, it will still have to keep an eye on global financing conditions. Risk aversion has already receded to its pre-pandemic levels, so is unlikely to contribute to a large rise in yields in the months ahead (see chart 8).
Even if the ECB does so, tighter Fed monetary policy could push up U.S. and world yields in the months and years ahead. That said, our findings suggest that even if U.S. 10-year yields rise from 1.5% now to 2%--its early 2020 level and our current fourth-quarter 2021 forecast from last March--this would only lift German Bunds by another 15-20 bps. All other things being equal, this would mean they would still likely be in negative territory at 0% from -0.2% currently, something the ECB could be happy to live with if economic and inflation data remains on track. This would also be in line with our Bund yield forecast of 0.1% for 2021.
|World Factor Weights Extracted Through The Principal Component Analysis|
|World yield (All AE)||PC1||World yield (Non-Eurozone AE)||PC1||World yield (Non-European AE)||PC1|
|10-year yield US||0.32||10-year yield US||0.37||10-year yield US||0.44|
|10-year yield AU||0.34||10-year yield AU||0.38||10-year yield AU||0.46|
|10-year yield CN||0.33||10-year yield CN||0.38||10-year yield CN||0.45|
|10-year yield NZ||0.33||10-year yield NZ||0.38||10-year yield NZ||0.45|
|10-year yield JP||0.32||10-year yield JP||0.37||10-year yield JP||0.44|
|10-year yield SW||0.34||10-year yield SW||0.38|
|10-year yield UK||0.34||10-year yield UK||0.39|
|10-year yield FR||0.34|
|10-year yield BD||0.34|
|Source: S&P Global Ratings.|
Research contributor: Maxime Brun. Editor: Rose Marie Burke.
S&P Global Ratings
- Coeure, B. (2018). The persistence and signaling power of central bank asset purchase programmes, Speech at the 2018 US Monetary Policy Forum, New York City, Feb. 23
- Ca' Zorzi, M. et al. (2020). Monetary policy and its transmission in a globalised world. ECB working paper series, No 2407 / May 2020
- Hofmann, B., & Takáts, E. (2015). International monetary spillovers. BIS Quarterly Review, September 2015
- Hördahl, P., Sobrun, J., & Turner, P. (2016). Low long-term interest rates as a global phenomenon. BIS Working Papers, No 574
- Rey, H., & Miranda-Agrippino, S. (2015). US Monetary Policy and the Global Financial Cycle. NBER Working Paper Series
- Moench, E. (2019). The term structures of global yields. BIS Papers chapters, Bank for International Settlements (ed.), Asia-Pacific fixed income markets: evolving structure, participation and pricing, volume 102, pages 3-15
This report does not constitute a rating action.
|Senior Economist:||Marion Amiot, Senior Economist, London + 44(0)2071760128;|
|EMEA Chief Economist:||Sylvain Broyer, EMEA Chief Economist, Frankfurt + 49 693 399 9156;|
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