Article / 19 October 2016 at 10:00 GMT

Weekly Bond Update: The end of free money

Fixed Income trader / Saxo Bank
Denmark
  • Fed, ECB may both end up tightening monetary policy at the same time
  • This would mark the end of the post-crisis easing period
  • Short-term pain might be favourable for bond investors

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 ECB president Mario Draghi is likely to face a raft of questions 
over the future of the QE programme tomorrow. Photo: iStock

By Michael Boye

For the first time since the global financial crisis, two of the world's most significant central banks – the US Federal Reserve and the European Central Bank – could be tightening their monetary policies at the same time, in what might be the beginning of the end of a remarkable long-stretched run of virtually free money and financing.

This Thursday, ECB president Mario Draghi can look forward to face a raft of questions over the future of the coveted QE programme, following a report earlier this month suggesting that the central bank is considering ways to scale down its support of European bond markets. 

The report caught the market somewhat off guard, as the over/under beforehand might even have been tilted in favour of more incoming support from Frankfurt – not less. In response, Eurozone government yields have risen across curves and countries. 

The benchmark 10-year German yield seems to have left the days of negative yields behind it, and is currently at a level of 0.05% testing levels barely seen since Brexit earlier this year. To be fair, it's hardly a revolution just yet, as any German maturities to and including nine-year remain in the negative.

Heat map of government bond yields:
Heat map Source: Bloomberg; Saxo Bank

What might be easily forgotten, perhaps blurred by the super-easing of the Draghi era, is that this is in fact not the first time the ECB has been contemplating tightening. Back in 2011 the central bank hiked its main reference rate not once, but twice, as then-president Jean-Claude Trichet reacted to rising inflation and didn't want to leave interest rates at emergency levels for too long. 

The interest rate was 1% before that move, by the way, and QE was an American phenomenon, and prohibited by European treaties.

What is different this time around, is that in the US, the Federal Reserve has already moved to hike interest rates once, and is widely expected to hike once more at its December meeting later this year. This means that the two most influential central banks could be tightening monetary policy at the same time, thus marking the end of the extreme easing policies that have been in place ever since the GFC in 2008.

The big question now is whether the policies have in fact fixed the underlying problems, or merely masked them by propping up their economies and not allowing malinvestments and markets to correct with a flood of easy money and exaggerated financial valuations. 

Now that the tide is about to withdraw, how will everything look? Clearly the market is concerned, as we have seen time and time again when the fear of Fed rate hikes has caused turmoil in financial markets.

However, the short-term pain might be favourable for bond investors, which may have to endure short-term price losses in order to enjoy higher coupons in the long run, especially if the alternative is to only kick the can further down the road by allowing the bubble in government debt to inflate further, which could very well end with a much more painful forced correction at a later point in time.

— Edited by Gayle Bryant

Michael Boye is a fixed income trader at Saxo Bank

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