Quantitative easing generally refers to a type of central bank policy which seeks to increase the liquidity in the financial markets by purchasing securities, most often government bonds. The practice was first adopted by the Bank of Japan (BoJ) and was later experimented by the Federal Reserve (Fed), the Bank of England (BOE) and the European Central Bank (ECB).
ECB’s QE was announced just a few months ago and is expected to amount to EUR60 billion monthly for 19 months. In the aftermath, consensus was positioned for a sharp fall in government yields although some voiced their concern that there were as well instances when yields fell in anticipation of QE and increased when it became effective.
Such comments are indeed accurate, as longer term yields are a function of long term growth and inflation expectations. Hence, to the extent that the QE announcement succeeds in abating growth and deflation worries, yields can indeed rise notwithstanding the presence of a new and determined buyer.
A case in point is the 2013 US experience when the 10 year yields spiked by 72 per cent although the expansion in Fed’s balance sheet amounted to 6.7 per cent of GDP, much higher than the budget deficit (a proxy of the new government bonds issued) which stood at 3.3 per cent of GDP.
Nevertheless, focusing on this example is misguided unless one thinks that ECB’s programme will be similarly successful. In my opinion the two central banks operate in completely differently environments, with two notable divergences impacting the QE’s potential to feed into the real economy: (i) the US corporates are more reliant on market funding whilst their European counterparts are over-reliant on bank loans (ii) the Euroarea includes many different economies, some of which are challenged by structural factors (eg. labour market regulation, bureaucracy etc).
Hence, in my opinion the QE programme initiated by the ECB has the potential to provide a confidence boost, lower bank lending rates, keep the EUR at lower levels but all of these will only serve to support growth in the short to medium term with limited, if any effects, on the longer term outlook. As such, the US experience over 2013 is hardly a point of reference in judging the upcoming trend in Euroarea yields.
To add to this, one has to consider that, over 2013, the Fed implemented its third QE programme. Similar exercises were carried over December 2008-March 2010 and November 2010-June 2011 which resulted in lower government yields; meanwhile, over 2008, 2010 and 2011, 10 year yields dropped despite budget deficits that significantly outpaced the size of the QE buying.
This should support the argument that besides the technical factors, such as the size of the central bank bond buying, what drive the longer end of the yield curve are the long term expectations.
For those who, like me, are sceptical about the sustainability of Euroarea growth and the normalization of inflation, a more relevant reference point is likely to be Japan’s QE.
Here yields fell every year during 2011-2014 even as BOJ was very aggressive in expanding its balance sheet (by 133 per cent). What happened thus is that investors found limited hope for the extra money supporting a normalization of the economy and, against this backdrop the yields became a function of technicals.
In 2014 for instance, the 10 year yield fell by over 50 per cent as the change in BoJ’s balance sheet significantly outpaced the budget deficit (15 per cent of GDP versus seven per cent of GDP). I would expect a similar faith for the German yields as the budget balance here is likely to be marginally positive.
This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit,www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.