For months, commentators, analysts, politicians and policymakers have been encouraging the ECB to do the decent thing – extend QE into government bonds.
In recent weeks, the pressure has built up as headline Eurozone inflation moved inexorably into negative territory. In a few days time, the central bank is expected to announce, with great fanfare, a programme to purchase up to €1 trillion of debt. One question remains important though – will it actually have any effect? In this note, we examine the various transmission channels and set out some triggers for investors to monitor.
In one respect, QE has already worked. An announcement effect can be seen in European government bonds and the currency, but less so in equities. Compared with six months ago, German 10-year bunds have declined over half a percent while the Euro has depreciated over 15% versus the dollar. This could be seen as an example of the success of Mr Draghi at manipulating European markets by talking rather than acting.
Such moves in financial prices need to be put into context though. It should be noted that the decline in bond yields has been widespread globally, while the US currency has appreciated against most trading partners. More importantly, any movements in the prices of European assets should be seen as a half-way house for the ECB. The key question for investors is: will the Eurozone economy itself turn around on the back of this decision to introduce QE? Here, the debate is rather less certain.
The experiences of the QE programmes in the US, UK and Japan do help in some respects. There are a variety of channels through which QE can affect the real economy, and also a variety of potential blockages in these channels.
The first is the impact QE can have on expectations. With headline inflation in negative territory, there is concern that more parts of the Eurozone could fall into entrenched deflation, a sustained decline in the general level of prices. US and UK QE announcements did prevent such an outcome – the worry about the ECB approach is that, rather than shock and awe, there has been a very public debate within the central bank about the need for such unconventional policy. A trigger to watch for is an open-ended commitment to QE continuing until inflation returns to target.
A second channel is through the decline in borrowing costs, not just feeding through into the governments’ finances but especially in the household and business sectors. One problem facing the ECB is that the credit transmission mechanism in Europe relies more on bank than bond finance. Although the ECB’s recent assessment of the banking sector did suggest some improvement, there is still much evidence that banks prefer to deleverage than lend. Indeed, there are few signs of a high willingness to borrow by many firms and consumers, against the backdrop of weak activity and sizeable unemployment. As a trigger, more capital raising by European banks in 2015 would be a sign that past problems are being put behind them.
A third channel is a wealth effect, via the price of financial assets, especially equity and property. If the discount rate (the benchmark bond yield) is reduced, with all other things being equal, the price of such financial assets should rise. A related aspect is portfolio rebalancing; when an investor sells bonds to the central bank via the QE programme they may re-invest the proceeds in other financial assets. One blockage to consider is that holdings of equity and commercial property in much of Europe are more indirect, through pension plans or insurance funds, compared with the situation in the US or UK, excluding a few European countries such as the Netherlands. A second blockage is the degree of financial regulation on banks and insurance companies, requiring them to hold more risk-free assets in order to strengthen their ability to withstand future shocks. One trigger to monitor is more rotation away from the US towards European assets, as a sign that investors are looking for new growth prospects.
The most important transmission mechanism may turn out to be the currency. A lower euro would boost import prices and support exporters, particularly useful if the US and UK economies continue to expand. A key question is how much of the QE is already priced in. Although the euro/dollar exchange rate has attracted attention by moving from 1.39 to 1.16 since mid-2014, it is more important to look at the trade-weighted currency movement, where the euro has only fallen 8% in the past six months. As a rough guide, each 10% decline in the trade-weighted euro adds up to 0.5% to Eurozone GDP growth.
All in all, our analysis emphasises that QE is necessary but not sufficient to turn the European economy around. A supportive central bank can help, however, there are a number of difficult issues facing the Eurozone. The banking system has not had the same degree of support as the TARP (Troubled Asset Relief Programme) did in the US to bolster balance sheets, for example. Labour markets are flexible in some countries, such as Germany, but across the region the rigidities are shown by structurally high levels of unemployment. While a number of peripheral economies score highly in terms of structural reforms, France and Italy are lagging. Lastly, the ECB programme would be more effective if accompanied by a significant fiscal expansion by national governments. However, Germany is resisting even though its public sector budget has returned to a small surplus. As far as the programme is concerned, if the ECB refuses to share risk, and instead requires each national central bank only to buy the debt of its own country, this raises worrying questions about future confidence in the Eurozone project, especially should the region falls back into a sizeable recession.
To sum up, we have set out a number of triggers in this note to examine the ECB’s announcement in terms of financial markets and the real economy. We see effects on the former, but remain to be convinced about the latter. Meanwhile, the House View remains Heavy in Eurozone bonds, and prefers US equity and the dollar to European equity and the euro.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
