Makrotalous

The ECB’s design of the QE programme provides some encouragement

The ECB has taken the plunge.

The central bank today announced its intention to buy €60bn in private and public sector assets every month starting from March. The design of the programme provides some encouragement.

  • First it is large. Current purchases of ABS and covered bonds are currently running at around €10-15bn a month. This implies around €50bn of sovereign bond purchases every month, which will aggregate into a meaningful balance sheet expansion. The total size will be equal to 12% of Eurozone GDP (the UK in contrast eventually reached 25% of GDP, over several rounds of QE).
  • Secondly the package is broadly open ended. It will be carried out until “at least” September 2016 and will run until the central bank is confident that it sees a sustained adjustment in the path of inflation. International evidence suggests that this sort of open ended programme linked to conditions in the economy is most effective.
  • Finally, the conditionality around the programme does not look too restrictive. The ECB can buy up to 33% of an issuer’s bonds and up to 25% of an issue. Maturities can range out to 30 years. Securities will have to be investment grade, although there will be special criteria for countries in an adjustment programme. Overall these conditions do not look like they will restrict the implementation of a large and broad based package.

Initially the market has taken the news modestly positively with equities up as the euro fell against the dollar. Bonds have rallied, especially at the long end, although this might reflect a shortage of safe assets as opposed to scepticism over the long term impact of the programme.

The principle of risk sharing will not be applied to losses/gains on these purchases. The ECB will hold 20% of the risk while the national central banks which carry out the transactions will hold the majority. Draghi sounded unhappy about this, but seems to have conceded the point in order to secure support for the programme. He was keen to emphasise that a lack of risk sharing will not affect the impact of the stimulus. Furthermore, the ECB has the OMT in its armoury, which does contain risk sharing between member states and would be used in times of stress. The threat is not immediate but as and when the Eurozone ever suffers worries about debt servicing, ie in a future recession.

Full blown QE in the Eurozone is overdue. The policy change today has finally implemented a more appropriate monetary policy setting for the struggling currency union. This should support inflation expectations and demand in the region. News this week that credit conditions have eased in the Eurozone should also provider encouragement that the transmission mechanism for this stimulus is slowly improving.

With monetary policy stimulus ratcheting up the onus now turns to other policymakers. Indeed QE does not provide a panacea for the Eurozone’s problems. Governments should accelerate structural reforms and loosen fiscal policy to take full advantage of this monetary boost. At present there are few signs of these proactive steps. With the ECB’s ammunition now running low policymakers can no longer rely on the central bank to drive further improvements in economic conditions.

Details

Size of the programme: €60bn a month of public and private sector securities, ie €1.1tn in total

Length of the programme: Until September 2016 and also “conducted until we see a sustained adjustment in the path of inflation”.

Types of bonds bought: Euro denominated investment grade securities issued by euro area governments and agencies and European institutions in the secondary market. Purchases will be made according to the ECB’s capital key, so for example about a quarter will be German.

Greek bonds included: yes

Maturity of bonds bought: 2-30 years, which was longer than expected

Risk sharing across central banks: 20% of the additional asset purchases will be subject to a regime of risk sharing. This comprises purchases of securities of European institutions amounting to 12% while the ECB will hold 8% of the additional asset purchases. The rest of the additional asset purchases by national central banks will not be subject to loss sharing.

Rates – no change in key rates; the pricing of the remaining six TLRTOs alters, a 10bp reduction to bring them into line with the Eurosystem’s main refinancing oeprations

The element of surprise

The markets were expecting the ECB to buy between €500-1000bn of bonds. As hinted at by speculation and rumours in the press in the last couple of days, the ECB has announced a programme which was slightly larger (€1.1tn) but also is slightly riskier in the long term as the degree of risk sharing is small (only 20%). This may worry some investors as and when the Eurozone ever enters a recession and debt servicing problems mount for some countries.

Impact on financial markets

Short-term, the Euro has declined modestly (as the programme was a little larger than expected) and therefore European stocks have risen modestly in early trading. The yield curve has flattened as maturities were longer dated than expected. Much of the news was clearly already in the price.

Longer-term, the sheer scale of bond buying across all maturities in the context of a relatively smaller pool of debt in the Eurozone should have a strong positive impact in driving down bond yields, particularly in the longer end where supply is limited. The degree of commitment and consensus on some of the key aspects to policy such as partial debt mutualisation should mean that this is only the start of a series of QE announcements from the ECB as they attempt to reflate Europe.

We think the impact on debt instruments should be clearly positive, but we are sceptical of the ECB’s ability to stave of the disinflation threat. In the absence of co-ordinated structural reform and support on the fiscal side from policymakers, the market will struggle to price in higher yields in the longer end government bonds. The more likely long term mover will be a continued mechanistic weakening of the Euro as the ECB embark on a series of QE tranches over the coming year.

Looking more widely, the decline in European bond yields has already affected other markets (eg the US and UK) while the decline in the Euro has affected other currencies (viz the decision by the Swiss National Bank). As far as today’s decision affects currencies, it will have implications for other central banks in Europe, through the exchange rate channel (eg Denmark, Sweden and the UK).

Political aspects

It appears the decision was consensus, not unanimous – more details may appear in the next few days. However, it has been clear that there is still German opposition to QE being too extensive, on the grounds that it will reduce the urgency for countries to reform their economies. This led to a trade-off in what risk sharing could be agreed at this stage.

Impact on the real economy

Mr Draghi states that “today’s measures will decisively underpin the firm anchoring of medium to long term inflation expectations”. As we wrote in this week’s Global Spotlight (on the web site), we are concerned that the transmission effect from QE to the real economy will be rather muted. There is unlikely to be a large announcement effect, as the QE decision is far from being a surprise. The portfolio rebalancing and discount rate effects should not be ignored but again this has been seen to some extent. The bank credit channel is improving, but hindered by the degree of regulation. QE may work most through the currency channel, albeit the Euro has already moved some distance and the impact on inflation or exports is somewhat limited. Put another way, QE would work better as part of a co-ordinated approach with fiscal stimulus and structural reforms, and at present that does not seem on the cards.

All in all, we expect the ECB’s programme to help stabilise the growth and inflation outlook for the Eurozone but we are not convinced that it will lead to a noticeable upturn in growth and inflation forecasts say in 2016-17.

Andrew Milligan, Head of Global Strategy, Standard Life Investments

James McCann – European and UK Economist, Standard Life Investments

Jack Kelly, Investment Director, Fixed Income, Standard Life Investments

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