You’ll want to mark 22 January on your calendars as a date to remember. Not because it’s the birthday of Lord Byron, nor that it’s the anniversary of the maiden voyage of the first “jumbo jet,” Boeing’s 747. Rather, 22 January is important because the European Central Bank (ECB) finally took the step of announcing quantitative easing (QE). The program announced this week by the ECB amounts to €60 billion per month in bond purchases of both sovereign and institutional European debt, as well as purchases under their existing covered-bond and asset-backed securities (ABS) purchase programs. According to the ECB, this will all start in March 2015 and continue until at least September 2016.
For a program that doesn’t even start for another month, it’s already had a positive impact on markets, probably because the amount of bond purchases announced by the ECB was larger than the market expected. The euro fell to US$1.12, this is its lowest level in at least 11 years. Inflation expectations in Europe have recovered to 1.72%. The news also boosted prices on Italian and Spanish 10-year bonds, pushing their yields down to 1.48% and 1.32% respectively.
If there’s a disappointment, it’s the risk-sharing provisions of the plan. Risk-sharing was very limited, which was a compromise to Germany and the more hawkish members of the ECB. That being the case, risk-sharing mightn’t be as important as it would initially seem. It isn’t a restriction on the size of purchases, nor does it raise the risk of default. It does, however, set back the idea of European integration.
The key move that’s caught attention, though, is the continued drop in yields on German bunds. With inflation expectations rising, the “reflation trade” would suggest that German bunds would’ve sold off sharply on the ECB news. What’s really going on is a tug of war between the reflation trade and market supply-demand dynamics. On the supply side, net issuance of German bonds will be very limited over the next two years. That lack of new issuance, combined with the ECB’s coming purchases in their new QE program, will put further downward pressure on German bund yields. All in all, inflation expectations would have to rise very sharply to offset the supply-demand fundamentals in a manner that drove up bund yields.
The implications for this move are undoubtedly positive for Eurozone growth. We expect to see QE weaken the euro, which should boost exports from the Eurozone. Rising asset prices should increase household wealth and induce spending, much like we saw in the United States during their term of QE. That said, this may be a struggle as long as labor markets remain weak and Europe’s fiscal stance is so contradictory. Sovereign QE should be positive for investment grade credit; as sovereign rates grind lower, investors should move from risk-free to riskier assets. Reviving the ABS market would also give investors a new asset class to buy that would directly link them to the real economy, but there’s still work to do on that front.
Our big caveat on all of this is that QE needs to be complemented by better fiscal coordination across the Eurozone’s member states, and we’d like to see it accompanied by further structural reforms. Without progress on these fronts, the efficacy of euro-QE will be limited in its impact on the real economy. Remember that when the UK, the United States, and the Bank of Japan embarked on their respective QE journeys, they were pumping money into much more growth-friendly environments that what the Eurozone now has. There’s still a hurdle in the way, but Europe now has a nice springboard to help it over the obstacle.
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