There has been much talk over the last two months on the possibility that the ECB might commence a Quantitative Easing (QE) programme to kick-start economic growth within the eurozone area.
QE is one of a number of policy options available to the ECB. In one of Mario Draghi’s recent speeches, the ECB president suggested that only if medium-term inflation projections had deteriorated substantially would the ECB consider a QE programme, hence we believe the central bank will only use this tool if there is a risk the economy falls back into recession. The probability is low; however, the possibility is still there. This article will hopefully give the reader an idea of how it will affect markets and asset classes.
Among other options available to the ECB, the following tools can be viewed as more likely to be used in the current economic environment:
Refi rate cut: a tool the bank would most likely use, together with a cut in its deposit rate as is expected at the June meeting. The market consensus is for a 10-15bp refi rate cut from the current 0.25 per cent;
Forward guidance: its effectiveness would largely depend on perceived credibility;
Further LTRO (Long-Term Refinancing Operations three-year operations started in 2011, although the ECB can choose for longer terms.
According to ECB staff, a QE programme of circa €1 trillion could boost inflation by 0.2-0.8 per cent up to 12 months later. The purchase could include sovereign bonds (this would be limited to secondary market bonds only), investment-grade corporate bonds, and asset-backed securities. Allocations between these broad classes will all depend on the respective size of these markets; the sovereign issues the ECB buys will understandably create a political issue. Do they buy by market size or capital key (countries “shareholding” of ECB’s subscribed capital); pro-rate by credit rating; will it penalise countries with excessive debt or deficits; or purchase debt of countries currently in a bail-out programme (Greece, Cyprus)?
Purchases of sovereign bonds will push European prices higher, putting further pressure on yields. Sovereign bond yields in the UK, Japan (last year) and the US (QE1, 2 and 3) reacted mostly with the initial announcement, slipping 50bp (US and UK) and 10bp in Japan (Japanese yields starting from a much lower place) – only to return to pre-QE levels three months later.
The current 10-year bund yield is 1.47 per cent, and one can assume that some QE expectation is already priced in. However, if we had to assume a further drop of 50bp, markets could be pushing 10-year bund yields to 1 per cent.
With this yield reduction we will probably also see credit spreads narrowing further. Even if the ECB did not target corporate bonds directly, investors will sell out of low yielding bunds, buying into other sovereign and corporate bonds with lower credit ratings. All this is great news for borrowers; bond investors, however, especially those looking for income, may not be so pleased!
European equity markets should also experience an uplift as a direct consequence of QE. The ECB could announce a programme as early as next month; at the same time the US Federal Open Market Committee is winding down its tapering programme, and the Bank of England could be looking at a rate hike. These events are all euro equity-positive. Why? While in Europe the “risk-free rate” used as a discount rate in pricing models will fall – hence higher equity values – a higher rate in the UK and less cash in the US system could make European equities look relatively cheaper. QE in Japan last year had a similar effect on Japanese equity prices.
Another reason equity prices might increase is tied to price-earning (P/E) ratios. The idea behind QE is to expand economic growth. This in turn increases expected corporate earnings, and prices would need to increase just to stay in line with pre-QE ratios. However, we could also see even higher P/E multiple as investors move into riskier assets – including equity.
The immediate effect on the euro should be one of weakness versus other major currencies (a by-product of expansionary tools), however it is unclear what could happen after this reaction. Most recently, Japanese easing led to a continuing sharp fall in the yen, however in the UK, sterling actually strengthened.
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This article is the objective and independent opinion of the author. The information contained in the article is based on public information.
Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Vincent Micallef is an executive director at Curmi and Partners Ltd.