The European Central Bank (ECB) was the most reluctant of the major developed world central banks to embrace quantitative easing (QE) following the global financial crisis. Having belatedly reduced interest rates to zero, it finally adopted QE in late 2014 in an attempt to fight deflationary forces and boost growth. The question is: will it work?
The euro zone recently emerged from a sovereign debt crisis (although Greece is still problematic), and remains stuck in an economic and political muddle which is hindering growth and perpetuating instability. As ECB President Mario Draghi has suggested, structural reforms, coordinated fiscal policy and greater institutional integration are all key to transforming the region’s prospects. Extraordinary monetary policy measures such as QE are necessary, but will not be sufficient to address the euro zone’s malaise.
Euro zone QE involves the purchase of €1.1 trillion of public and private assets, predominantly government bonds, paid for with money ‘created’ by the ECB. The programme commenced in October 2014 with the purchase of asset-backed securities (ABS) and covered bonds. QE has since been expanded to include government bonds and will run for 19 months from March 2015, or until “a sustained adjustment in the path of inflation” is achieved towards the ECB’s target of just below 2%.
The primary justification for QE is to avert the risk of deflation, such as that experienced by Japan in the 1990s and 2000s. In theory, QE can help restore growth and inflation pressures through a combination of asset price inflation, easier credit conditions and currency depreciation. QE also has the advantage of partially monetising the euro zone’s large government debt burden, although heavily indebted countries are not specifically targeted. While the precise impact of QE is difficult to assess, it is likely to be beneficial at the margin. The policy is not without risks, though, and the deep structural vulnerabilities of the euro zone currency union will remain.
Helping to restore growth and inflation
Positive wealth effects
ECB asset purchases will crowd out other investors, push yields lower than they otherwise would have been, and generate capital gains for asset holders in the short to medium term. This is consistent with what has occurred since the announcement of QE. As yields fall, investors are encouraged to take on more risk in search of higher returns. This ‘reach for yield’ will flow through to other asset classes, causing asset prices to rise broadly and creating a positive wealth effect that could support economic growth and consumer price inflation at the margin. Investors should be cautious about adjusting their expectations of long term risk adjusted returns in the euro zone, however, as the effect may turn out to be transitory.
Lower borrowing costs
Falling yields and spreads should also reduce borrowing costs for businesses and governments. Although, the impact is likely to be more muted in the euro zone than in the US, as most corporate borrowing is channeled through the banking system rather than bond markets, and government bond yields are already very low.
A flood of excess liquidity in the banking system under QE may also support lower bank loan rates, potentially inducing households and corporates to borrow more. In this regard the impact of QE is difficult to disentangle from other measures such as the ECB’s targeted long term funding obligations (TLTROs) which directly lowers funding costs for banks. Small businesses and households still face difficulties accessing finance at reasonable interest rates, especially in the euro zone periphery, a problem that QE is unlikely to address.
On the other hand, yields may rise if economic fundamentals or expectations improve, or if investor risk aversion shifts. There is some evidence that this occurred for 10 year US Treasury yields during QE by the Federal Reserve. Alternatively, an adverse macroeconomic shock could cause the yields of riskier assets, such as Portuguese government bonds, to spike.
Currency depreciation is another important transmission channel for QE. Lower yields reduce demand for euro denominated assets, while ECB money creation increases the supply of euros, putting pressure on the euro to depreciate. Since the announcement of QE the euro has depreciated materially against the US dollar. This will provide a boost to inflation and growth as the cost of imported goods rises and the externally exposed parts of the economy become more competitive.
Future inflation and interest rate risks
There is much debate about the potential inflation and interest rate risk associated with QE in the long run. While there is little evidence of inflation pressures in the US or UK at this stage, we cannot rule out this prospect when the global economy returns to full capacity given the massive growth in base money supply in recent years. Investors should also note the potential for yields and spreads to increase following the conclusion of QE, or under any future sale of assets. At present the ECB has not articulated a QE exit strategy. However, with euro zone unemployment currently at over 11%, inflation and interest rate pressures are likely to be some way off.
Macroeconomic shocks could be destabilising
The euro zone is not immune to macroeconomic shocks. For instance, there is a risk that rising US interest rates could be disruptive to euro zone bond markets. Currently the spread between 10 year US Treasury yields and German Bunds is at record highs. A tightening US labour market could prompt rate rises by the US Federal Reserve, placing upward pressure on euro zone yields.
Yield and spread compression has been a feature of financial markets in recent years. Should this rapidly unwind, it could disrupt euro zone stability. European periphery nations could face a potential ‘triple whammy’ scenario as they did in 1994 when the US Federal Reserve increased interest rates. This could happen through rising US Treasury yields, a normalisation of the spread between Treasuries and Bunds and a widening of the spread between Bunds and periphery government bonds.
Even if QE helps to restore inflation at the euro zone level, the sustainability of government debt may remain an issue in highly indebted, weak economies such as Greece, Portugal and Italy. Future debt restructuring, defaults or the election of eurosceptic parties could prompt a reassessment of euro zone sovereign risk premia.
The euro zone remains vulnerable to an escalation of the Russia/Ukraine crisis or a China hard landing. Either of these scenarios could cause a dramatic uplift in the yields of troubled euro zone government bonds and seriously test the ability of the ECB to intervene in bond markets in an unlimited way.
QE is important for global investors as it has implications for yields, growth, inflation and systemic risk. Although it will probably be beneficial at the margin, QE is unlikely to be a silver bullet for the euro zone’s deep structural problems. Investors would be unwise to materially adjust their expectations of long run risk adjusted investment returns in the euro zone based on the implementation of QE alone.
Sam Churchill is the Head of Macro Research at Magellan Asset Management. This material has been prepared by Magellan Asset Management Limited for general information purposes only and must not be construed as investment advice. It does not take into account your investment objectives, financial situation or particular needs.