The ECB crosses the Rubicon

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  • The ECB’s decision on 22 January 2015 to launch quantitative easing sends a strong signal on the strength of its commitment to combating the deflationary risks confronting the eurozone economy.
  • In our view the measures are sufficient to achieve at least the targeted expansion of the ECB balance sheet that so far now far has proved illusive.
  • We note that the ECB is ready to scale up activities, should this be needed. January 21 2015 therefore marks not the end of a journey but just the beginning.

As Julius Cesar’s army crossed the Rubicon river in 49 BC so the ECB passed a point of no return on January 22 2015 in announcing a programme of quantitative easing (QE).

The combination of a number of factors have, in our view, pushed the ECB into taking this more aggressive action, namely:

• Difficulties in achieving the expansion of the ECB’s balance sheet to meet the target of EUR 1 000 billion that was set in June 2013.
• Fragile economic growth in the eurozone.
• The recent fall of the eurzone’s headline inflation rate into deflationary territory
• Signs that forward looking indicators anticipate rates of inflation below the ECB’s targets.

The ECB’s principal message is that it is trying to secure its target of longer-term price stability – in other words, to minimise the risk of a deflationary spiral. As has been the case in the past, today’s decision will provoke discussion as to whether the ECB’s chosen measures will be sufficient.

Looking back, there has been some consistency in ECB policy decision-making: always a little hesitant, not taking proactive action like the Federal Reserve, always responding to the changing economic environment, but ultimately delivering.

This ‘gradualist’ approach regularly disappoints many market-watchers, but this time there is a difference. By taking the decision to buy government bonds, the ECB has cleared an important hurdle. If further ‘beefing up’ of the programme is needed, it will be much easier to achieve with government bonds than would have been the case had the investment universe consisted only of less liquid sectors of bond markets.

The ECB’s latest action should prove an effective means of preventing deflationary expectations becoming embedded in the behaviour of trade unions (with regard to wage negotiations) or companies (with regard to pricing policy).

Another important outcome is clarification of forward guidance. The surprise move by the Swiss National Bank last week was a reminder that investors and central banks can interpret things quite differently. For the ECB, market guidance should be quite straightforward over the next couple of years – namely, that money markets rates will be kept low and asset purchases will be a support for capital markets. It is in any case just the start of a long journey, not the end of one.

• The ECB will buy government bonds to speed up its asset purchases and achieve the targeted expansion of its balance sheet.
• From March 2015 onwards the ECB intends to buy EUR 60 billion of private and public bonds per month until at least September 2016.
• There will be no full sharing of the risks among those participating of the risk involved in purchasing government debt.
• For future TLTROs (Targeted Long Term Refinancing Operations), the 10bp spread will be eliminated.

Due to the pooling of purchases of private and public debt the total impact of this QE announcement is somewhat difficult to assess. It seems to be towards the upper end of market expectations, it speeds up activities and should be sufficient to achieve the intended balance sheet expansion over the proposed time horizon. It offers the option to take things further if need be. Certainly there have been no immediate extreme market reactions, which suggests the ECB may have found the right balance to deal with elevated market expectations.

It is more obvious to us that QE will prove effective for financial markets than it is for the real economy. QE is positive for risky assets. The outcome for bond markets is more ambivalent as yields are already extremely low. If it was a fear of deflation that triggered the recent plunge in bond yields, then shouldn’t  an anti-deflationary policy contain some risks for bond markets? “We’ll worry about that later”, seems to be the response of markets – for the time being the focus is on the implicit support from the ECB’s buying of bonds, which should at the very least act to cap any rise in yields. This is a situation that would allow investors to consider trading strategies that will earn money from the yield curve’s steepness and changes in market volatility over a prolonged period.

Further spread tightening in the eurozone seems likely, as the search for yield is given fresh impetus in an environment where risk premia are already low on account of the ECB’s previous policy measures. Another point to highlight is that the recent plunge in yields is probably also driven by a search for safe havens (or at least a search for havens that don’t involve the negative interest rates now affecting parts of core sovereign yield curves) or by investors seeking to balance risks and liabilities. With Germany moving to a balanced budget a negative supply-demand balance should mechanically keep yields low or contribute to  even lower yields for bunds.

The ECB’s decision against a full sharing of profits and risks among EMU member states is, in our view, a point of weakness. For 20% of purchases (8% by the ECB, 12% for European institutions) there will be risk sharing among central banks (12% of which will be in agency bonds (e.g. EIB) with 8% by the ECB itself) but not for the remaining 80% of purchases by national central banks in line with their capital quota. This seems more a political concession to address the concerns of some countries, but it should not be an obstacle to the programme’s effectiveness. In a “hypothetical” negative scenario there would ultimately be risk sharing. Given this approach, the Bundesbank can implement ECB policy – whether it had voted for it or not – taking a “potential risk” could be the starting point for another complaint at the German constitutional court and some uncertainty for markets. A ban seems unlikely given the apparent nod on broad monetary policy leeway from the Advocate General at the European Court of Justice.

Another unanswered question concerns the potential impact QE will have on appetite for reform among eurozone governments. The ECB has to go to the limits of its mandate as it is the only eurozone institution that can make quick decisions. Lowering the interest cost of debt will be a highly welcomed relief for governments struggling with heavy debt loads, but it could provide an excuse for them not to do their part of the job. The longer they take to implement reforms, the higher the pressure will become to ultimately implement them. This is a long-term issue that should be followed with attention: will today’s ECB decision prove to be a step forward toward better fiscal coordination and integration in the eurozone? Or will it simply postpone another eurozone crisis?

For the real economy, the potential impact of QE will in our opinion be limited and less effective than it has been in the US. This is explained by the fact that Europe’s economy relies more on loans from the banking system for its financing, than from funding via the direct issuance of bonds in capital markets. Wealth effects are also likely to be lower. The positive effect should be less negative sentiment about deflationary risks and an improvement in the anticipated rates of economic growth.

But the most positive impact for the real economy should be that QE will keep the euro weak. Exports account for some 44% of the eurozone’s GDP. So a weaker currency is of far greater importance to the eurozone than it would be to the US or Japan, where exports account respectively for just 13% and 17% of GDP.

Written on 22 January 2015

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