By Dhara Ranasinghe
LONDON (Reuters) - The European Central Bank has its work cut out this year to make sure markets don't jump the gun on its policy normalization.
Currency strength and a doubling of benchmark borrowing costs over just two months may be tightening euro zone financial conditions faster than the ECB would like, potentially jeopardizing its timeline to exit stimulus.
The central bank has successfully engineered a recovery from the economic doldrums via three years of hefty asset purchases known as quantitative easing (QE).
But as investors anticipate a retreat from extraordinarily loose monetary policy, too fast a rise in bond yields could undermine that good work and make it harder for inflation to rise toward the ECB's near 2 percent target.
GRAPHIC: http://reut.rs/2BATI4q
Some factors, such as the spillover effect from U.S. borrowing costs, will be beyond the ECB's control.
That means the bank must tread carefully when signaling policy steps through "forward guidance", a key influence on longer-term borrowing costs given market players' propensity to interpret bankers' signals and front-run the actual decision.
Long-term borrowing costs in powerhouse economy Germany have roughly doubled in the past two months. At 0.74 percent (DE10YT=RR), they are close to a 2-1/2 year high, thanks to robust economic data, higher U.S. inflation and expectations that ECB stimulus will end sooner rather than later.
"Financial conditions have tightened, so the market should assume that it will take longer for the ECB to reach its inflation target," said Kim Liu, senior fixed income strategist at ABN AMRO (AS:ABNd).
"But everyone is expecting an early exit from QE and also rate-hike expectations have risen. I'd like to know how the ECB is going to solve this."
The ECB's 2.55 trillion euro bond purchase scheme is due to run at least until Sept. 30. Economists polled by Reuters then expect short taper to wrap it up by year-end, although some policymakers have even questioned whether the scheme needs to run beyond September.
Monetary conditions in the region are at their tightest since late 2014, according to a European Commission index.
ABN AMRO senior economist Aline Schuiling said that tightening was reflected by the fact that the weighted average bond yield for the euro zone is at around 1.23 percent versus a 2018 forecast of 1.1 percent made by the ECB in December.
The euro's exchange rate against the currencies of its main trading partners is already up 7.5 percent year-on-year, she said, against the ECB's December assumption that the trade-weighted euro would appreciate an average 2.8 percent this year.
Trade-weighted euro is close to its highest since September 2014, pushing down on the price of imported goods and in turn inflation.
According to BNP Paribas (PA:BNPP), a 10 percent rise in the euro corresponds with a fall of nearly 0.5 percentage points in inflation over the next 12 months.
Every 10 percent rise in the trade-weighted euro lowers companies' earnings-per-share by 5 percent, Deutsche Bank (DE:DBKGn) estimates.
VOLATILE
While higher bonds yields are an expected consequence of a stronger economy, it is the speed and pace of the rise that concerns policymakers.
The surge in yields has taken analysts by surprise and, just weeks into 2018, many have lifted their 2018 forecasts.
"It is true that financial conditions have tightened, not in absolute terms to a point where it jeopardizes the expansion, but the pace, whether through the currency or rates or peripheral bond spreads moving forward, is important," said Pictet Wealth Management economist Frederik Ducrozet.
"That is a source of concern and the one factor that could potentially be a game-changer for the ECB."
He said if U.S. yields are trading at 3 percent by the ECB's March 8 meeting and euro area bond-yield spreads widen, a more dovish ECB tone is likely.
Policymakers have shown no sign so far of recalibrating their guidance. ECB chief economist Peter Praet has said the bank "can live" with the recent spike in market volatility as long as it does not hurt financial sector stability, while board member Benoit Coeure noted higher volatility was largely confined to equities.
Analysts say they may be reassured by the limited rise in yields on bonds of southern European countries like Spain and Portugal, whose 10-year spreads versus German debt are near their narrowest in eight years (ES10YT=RR) (PT10YT=RR).
The yield premiums investors demand to hold their debt compared to super-safe German bonds are a key gauge of relative risk, and viewed as vulnerable to a withdrawal of ECB stimulus.
"Currently, the stronger euro and higher bond yields are a small double whammy for the ECB," ING Bank analysts told clients. "Monetary and financial conditions have become less accommodative in recent months, but the overall level remains low."
There is also the risk that U.S. bond yields spike further (US10YT=RR), piling upward pressure on European borrowing costs.
"The big thing the ECB can do nothing about is the march of U.S. yields," said David Vickers, a senior portfolio manager at Russell Investments.
"I don't think the bond sell-off gets disorderly but it feels a bit like that because we've had low yields for so long.
"Markets were complacent last year as we had strong growth and low inflation and just a little repricing of that and we get a mass sell-off in every risk asset."