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How Markets Could Come Out of the Shadows

23 Jul 2017 2:00 pm
By Justin Lahart 

The European Central Bank has reached the same spot the Federal Reserve reached four years ago. For financial markets on both sides of the Atlantic, it is an event that comes with consequences.

In May 2013, then-Fed Chairman Ben Bernanke told Congress the central bank later that year might begin tapering its asset purchases -- remarks that sent Treasury yields sharply higher, and ultimately forced the Fed to push back its plans. The ECB is keen not to relive the so-called taper tantrum. Following its meeting on Thursday, President Mario Draghi took care to not lay out any sort of timetable for when the central bank will start reducing purchases.

But, as with the Fed in 2013, an improving economy is putting the ECB on the path to eventually ending its bond purchases and, if nothing goes badly awry, tightening. Throughout that process, even as its benchmark interest rate remains stuck at zero, financial markets will need to undergo a substantial adjustment.

One way to gauge how big the adjustment needs to be is to look at the ECB "shadow rate" constructed by economists Jing Cynthia Wu and Fan Dora Xia. Calculated with the rates on longer-dated credit instruments, this gauges where the ECB's benchmark rate might be if it could be set meaningfully below zero. It is, in effect, a measure of how stimulative the ECB's unconventional monetary policy is. At minus 5.1% as of last month, the ECB shadow rate is deeply negative.

The lowest the comparable U.S. shadow rate reached was minus 3% in mid-2014, when the Fed was in the midst of tapering. From there it climbed, reaching the zero level in November 2015 -- the month before the Fed raised rates for the first time. It was a period when the yield on 10-year Treasurys remained low, not least because bond purchases by other central banks were draining the supply of long-term government bonds available to investors.

But it was also a period that coincided with a sharply stronger dollar. In effect, adjustments that in the past, when global markets weren't as integrated, might have flowed through into higher long-term rates showed up in exchange rates instead. Ultimately, the dollar's strength caused problems. In early 2016, for example, worries emerged that emerging-market debtors wouldn't be able to repay dollar-denominated loans.

As European credit markets adjust for an eventual ECB tightening, and as the ECB shadow rate rises, the euro may rise sharply against other currencies, including the dollar. In contrast to what happened during the Fed's shadow rate rise, long-term bond yields also could move higher since there will be one less central bank draining supply. The world that investors find themselves in will look a lot different than the one they are in now.

Write to Justin Lahart at justin.lahart@wsj.com

(END) Dow Jones Newswires

July 23, 2017 10:00 ET (14:00 GMT)

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