The ECB's QE program: Don't judge a book...
March 19, 2015
The European Central Bank’s (the ECB’s) historic quantitative easing (QE) program, which commenced operations on Monday, March 9, is a unique animal. Despite the temptation for onlookers to draw similarities, the program is not quite like the rounds of easing undertaken by other major central banks since the end of the global financial crisis.
In fact, the differences are stark:
- First, the European program is getting under way in an environment of exceptionally low yields, and indeed yields are dipping into negative territory in some countries. (By contrast, programs undertaken by other banks — the U.S. Federal Reserve is a notable example — started with higher yields.)
- Second, the ECB’s program relies on many sovereign banks to execute the bond buying; in the United States, the Fed was the sole conductor.
- Third, euro-zone members are grappling with an overload of debt (public as well as private), while certain regions around the world are not as burdened in this way.
Given the distinctive qualities of the European scenario, we see at least two questions that we believe investors should be thinking about:
1. Will it work?
Yields are already stubbornly low, raising doubts about the practicality of the ECB’s bond purchases. At this writing, approximately 25% of euro-zone government bonds trade with negative yields, while debt issued across many countries has been pushed down to record lows. We think yields could stay exceptionally low for a good while, perhaps a matter of years (not just weeks or months).
Looking at the euro zone’s continued bout of low interest rates, we think there’s a valid concern that markets might not be deep enough to support big rounds of bond purchases. In other words, there’s a chance that the ECB may not be able to fulfill its monthly purchase targets. This risk is somewhat further inflamed by the ECB’s decision to set a yield floor of minus 20 basis points (or -0.20 percentage points) on sovereign debt being purchased through the program. All in all, we think these factors provide good reason to question what the contours of the bond market will look like as the buying gets under way in earnest.
2. How much rotation is likely to happen throughout fixed income sectors?
One irksome reality that we think investors will contend with is the probability of erratic flows between different types of bonds. With policy measures presumably keeping sovereign yields relatively fenced in, consequences are sure to follow; at the very least, we think it’s possible that traditional holders of government debt will be drawn to investment grade bonds, while investors who usually favor investment grade debt will cross over to the high yield realm. There will be some uncertainty as to the degree and timing of this migration, and we will be monitoring its effects on asset prices.
We also believe that given an environment of negative yields, funding may be scarce in primary markets because many traditional buyers will probably retreat from primary issues. Assets may therefore be reallocated to more-liquid sectors that harbor better risk-adjusted yields.
An ocean of vinegar, a drop of honey
In addition to the headwinds noted above, let’s point out that the ECB has already tried to stimulate the European economy. It has procured generous loan packages and lowered short-term rates. Still, the euro bloc has not broken free from its trend of weak growth and low inflation. Does this questionable track record cast a negative shadow on today’s QE efforts as well? While it’s too early to make definite assertions, we think it makes sense to view the program through a cautious lens.
When it comes to helping lift inflation, we believe the QE program may have a muted effect. Ostensibly, the program is intended to nudge inflation higher by weakening the euro. However, central banks in other major economies have raced to weaken their currencies as well. See Currency markets contend with a devaluation dilemma. Currency markets contend with a devaluation dilemma.
Currency markets contend with a devaluation dilemma. With these inflation goals out of the question, perhaps the best we can hope for is that the quantitative easing program provides a window of time for countries to pursue the structural and fiscal reforms that are sorely needed. (These fundamental problems need to be seriously addressed.)
As a closing note, perhaps we can slightly offset all of this bearish sentiment with one positive observation: In the coming months, we believe the ECB’s easing program may help limit the downside risks that peripheral European countries could face should there be credible indications of Greece leaving the union.
The views expressed represent the Manager's assessment of the market environment as of March 11, 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increased the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.