“Not to pursue our mandate would be illegal” is how Mario Draghi ended his last press conference of 2014. His first press conference of 2015 began with the announcement of a quantitative easing (QE) programme that pursues the European Central Bank’s (ECB) inflation mandate with a vengeance.
ECB QE modalities
Beginning in March 2015, the ECB will purchase €60 billion worth of bonds per month until September 2016, implying a total of €1.14 trillion in asset purchases across eurozone government and agency bonds, covered bonds and asset-backed securities (ABS). We estimate the monthly purchases will comprise approximately €40 billion – €50 billion worth of government bonds, €5 billion – €10 billion of agencies and €5 billion – €10 billion of covered bonds and ABS. Because the markets for agencies, covered bonds and ABS are relatively small and their supply less predictable, the share of government bonds will likely vary up and down from month to month to meet the €60 billion quantity target.
By making QE state-dependent on inflation, the ECB’s purchase programme contains a degree of open-endedness that implies an extension of the programme if necessary. Purchases will continue to at least September 2016 or until “we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term” (my emphasis). With inflation currently at −0.6% and the ECB forecasting 1.3% inflation in 2016 – and that was before the price of oil fell to $50 a barrel – a sustained adjustment in the path of inflation back toward target may take a while to achieve, hence the possibility to do more beyond 2016 if necessary and our conclusion that the ECB is now taking its mandate very seriously indeed.
Purchases will span bonds with maturities from two years to 30 years and include Greek and Cypriot bonds if these countries are compliant with conditions under the terms of their reform programmes with international creditors.
Of all the bonds purchased under QE, 20% will be subject to so-called risk-sharing, meaning any loss on this portion of bonds will be spread over the Eurosystem of central banks – the ECB and its 19 paid-up national central bank (NCB) shareholders – in proportion to their capital subscriptions in the ECB. The remaining 80% of bonds will not be subject to risk-sharing. For this portion, each NCB will buy its own government’s bonds and bear the default risk. In the unlikely event of a government defaulting on its bonds, only the defaulting government’s NCB will participate in the loss.
While this form of several liability could be considered a signal of disunity within the Eurosystem, it is not, because risk-sharing applies only to the asset side of the balance sheet, not the liability side. QE involves the Eurosystem, ECB and NCBs, buying bonds from banks in return for euro reserves, which are liabilities of the Eurosystem. These euro reserves are cross-border fungible, meaning banks can enforce their claim on euro reserves created by QE anywhere in the eurozone. In the hypothetical event that a eurozone government defaults, causing its NCB to default too, private banks’ claims on euro reserves are still money good because they can be enforced anywhere else in the eurozone. In addition, central banks can operate on negative equity. So risk-sharing is – as Mr. Draghi said in the press conference – “irrelevant.”
Will QE work?
Let’s not kid ourselves: Monetary policy can help steer the short-term business cycle, but sustainable growth ultimately derives from investment, productivity and population growth. And for that, both the private and public sectors will be required to contribute their parts too.
European policymakers appear to have struck a grand bargain of sorts, involving three parts, that suggests this QE programme can be successful if governments cooperate too. Monetary stimulus is the first part, which the ECB has delivered with QE by lowering interest rates and the external value of the euro.
The second part is investment. The European Commission has launched a plan to mobilise public and private investment in an effort to kick-start growth. Boosting the European Investment Bank’s capital is the central part of the plan, which involves creating a European Fund for Strategic Investment (EFSI). The EFSI will target infrastructure and investment projects by small and mid-cap enterprises over 2015–2017, especially in Southern Europe where investment is needed most. While the EFSI will be funded with only €21 billion in public money that will be targeted at the subordinated tranche of each investment project, it hopes to attract just under €300 billion of private co-investment in equity and senior tranches. If it succeeds, the EFSI’s investments would be equal to about 2% of European national income.
The third part of the policymakers’ grand bargain involves reforms that boost growth and economic efficiency, and on this front a number of eurozone governments are finally getting serious. Prime Minister Matteo Renzi stands out for reform initiatives of Italy’s labour market, electoral system and banking sector, and while not every reform has been passed into law yet, in this regard Europe is definitely improving.
Overall, we think the combination of QE, investment and lower oil prices will increase eurozone growth by about 0.3% to reach 1.3% for 2015.
A generalisation of QE experiences in the U.S., U.K. and Japan suggests QE is good for risk assets and bad for duration and the external value of the currency being printed. Japan is the exception with regard to government bond yields. Whereas bond yields rose in the U.S. and U.K. after QE began, they continued declining in Japan, probably because the Bank of Japan bought and continues buying so many of them and because other government policies have contributed little to boosting potential growth.
We think risk assets in the eurozone and the euro will experience similar dynamics as the other QE countries. The low supply of new eurozone government bonds relative to the quantity the ECB plans to purchase suggests the future path of eurozone yields will more closely resemble the experience in Japan. For calendar year 2015, we estimate the net supply of eurozone government bonds (the amount issued to finance budget deficits) at about €270 billion and the gross supply (the amount issued to refinance old debt and fund budget deficits) at about €900 billion – please see Figure 1 for a country-by-country breakdown. Given €400 billion – €500 billion in additional demand from the Eurosystem for the remainder of 2015, and considering that some investors are obliged to invest in eurozone government bonds, it is difficult to picture how their yields could rise.
Peripheral government bonds have performed well in recent years, but we see few reasons to part with them. At about 2.5%, yields on longer-maturity Italian and Spanish government bonds offer a not-insignificant pickup over similar maturity bonds from Germany. We would expect these yield differentials to diminish.
We continue to see opportunities in investment grade and high yield corporate bonds. Eurozone bank stocks and subordinated bank capital securities have underperformed their corresponding sovereign bond markets of late, and the ECB’s actions should be supportive of some catch-up.
Where we see less value in the eurozone is in the ultra-low yields, including securities with negative yields, on core country government bonds and in currency exposure to the euro.
More generally, further out what PIMCO calls the investment concentric circles, less liquid and higher-risk asset classes such as stocks, high yield, bank loans, distressed debt and real estate should benefit from easier global monetary policy. Although the Federal Reserve (Fed) stopped purchasing assets in 2014, the Bank of Japan (BOJ) and now the ECB have stepped up buying bonds where the Fed left off (see Figure 2). The combined balance sheets of these three central banks, measured using the International Monetary Fund’s Special Drawing Rights (SDRs), a type of global currency, are set to expand by over 1 trillion SDRs by the end of this year, on par with the peak expansion rates during early 2009 and 2012. If history is anything to go by, this global liquidity expansion should be supportive of risk assets.
These international ramifications of ECB QE are perhaps the most interesting and important for investment strategy. The world economy has experienced 35 years of broadly uninterrupted disinflation that culminated in zero policy rates and QE in all major developed markets. While cyclical economic strength is re-emerging in the U.S. and the U.K., the sheer weight of slower growth in the rest of the world, particularly when China and other emerging markets are brought into the equation, and particularly in light of aging demographics, has implications for just how far the Fed and Bank of England can normalise their policy rates. China’s economic, monetary and exchange rate policies will be pivotal in this respect.
China’s yuan has become the strongest major currency in the world since 2000 measured on a real effective exchange rate basis, which compares the external value of a country’s currency against its major trading partners adjusted for inflation (see Figure 3). With China having experienced a classic, credit-fueled real estate boom and now bust, it is only a question of time before the People’s Bank of China eases monetary policy more aggressively. If lower reserve ratio requirements and policy interest rates do not suffice to cushion China’s growth slowdown, a devaluation of the yuan cannot be ruled out, a move that would likely stop the Fed’s interest rate normalisation in its tracks. Judging by the relentless flattening of the Treasury yield curve, which is partly attributable to global influences, the market to some extent is already discounting for the next U.S. business cycle slowdown before the Fed has even achieved its first fed funds rate hike.
Markets continue to believe in the power of central banks to engineer economically desirable outcomes. Should that belief be called into question, in much the same way that (for example) PIMCO’s thesis of The New Neutral calls Fed policy normalisation into question, and should central banks throw in the towel as the Swiss National Bank did, that decades-long disinflation trend could tip into debt-deflation.