Jan 23, 2015 - Jeffrey Rosenberg
The European Central Bank on Thursday delivered basically what the market expected for QE: 60 billion euros of purchases per month directed at investment-grade-rated government and agency debt and with a total size, considering the contemplated end date by September 2016, of around one trillion euros. The modest decline in the euro and further declines in European bond yields, along with compression between peripheral and core bonds, all reflect the success of a QE announcement in line with market expectations.
Importantly─and with the usual caveats of smaller market liquidity─inflation expectations signaled from inflation-linked bonds and the ECB’s oft cited five year, five-year forward measure of inflation increased on the day. That trend towards higher inflation expectations continued into U.S. inflation expectations, indicating that the ECB QE announcement, and coincident with tentative signs of stabilization of oil prices, may mark the low point of deflationary fears driving global interest rates to new lows.
The surprises, if any, were to be found in Draghi’s Q&A session and in his more off-scripted moments. We consider two to be critical.
1. The maturity range of purchases. Having not been laid out in the prepared remarks, Draghi answered this question most casually. But as can be seen by the chart below, the casual extension of purchases out to 30 years appears not to have been the market expectation, as the clarification led to the most dramatic of market moves associated with the QE announcement.
This turnabout also appears to have turned overall yield sentiment. Whereas the initial reaction to the 60-billion-euros-a-month announcement of higher yields might have reflected some disappointment, Draghi’s clarification on maturity reversed that interpretation, leading to lower rates across the curve, the continent and spilling over into all global bond markets.
2. Clarification of whether the plan will work. We found the candid remarks to a question by Brian Blackstone of The Wall Street Journal to be a crucial interchange. Blackstone asked why the financial markets should think the plan will work in terms of boosting inflation and restoring economic growth and employment in the eurozone. Draghi offered a handful of reasons, but also noted that while monetary policy can build the foundation for growth, it’s up to government policy to implement vital structural reforms, a point he has stressed on many occasions.
As we highlighted in our 2015 outlook piece, there are significant differences between how we should expect QE to benefit the real economy in Europe relative to how it benefited the economy in the U.S. In the latter case, the benefits from what Draghi called substitution (and what the Fed calls the “Portfolio Rebalance Channel”) are limited to just the lending impacts he describes. As such it is hard to imagine, given the ample liquidity support and incredibly low (and negative) interest rates already entrenched in Europe, how expanding QE will lead to further real economy benefits from this channel. In the U.S. those further benefits crucially flowed through the wealth effect channel: substitution of lower risk assets such as bank deposits and Treasuries for high yield bonds and equities led to price increases in those risky assets. That broad based asset inflation, including critically the intended recipient house price inflation, led to rising consumption, a pattern well entrenched in the U.S. economy.
Such a relationship has no basis in the European economy (and as we pointed out in our outlook piece, in the case of Germany actually shows some evidence of the opposite of the intended effect, as rising wealth is associated with rising savings rates and reduced consumption). Hence the main and, per Draghi, unintended transmission mechanism to the real economy lies in the currency. Since it’s unacceptable for global central bankers to directly target the currency as a policy tool, Draghi refers to the currency impacts as effects of the policy, not targets.
That leaves fiscal policy and structural reforms as the critical and necessary next steps to support economic recovery in Europe. But those steps require political will and hard and risky choices for democratically elected leaders facing an increasingly euro-skeptical and polarized electorate. Which brings us to the ECB’s QE paradox: in such a political environment, only significant market or economic pressure can bring governments to make such difficult decisions. A clear mandate of governing majority is required to undergo such a politically fraught exercise. Even in the case of Japan, where arguably Abe has such a political opportunity, he still faces entrenched opposition to imposing his “third arrow” structural reforms.
Today’s low public opinion of Europe’s governments suggests few would or could be expected to follow this path. And absent the bond market pressure that Draghi has so successfully done “whatever it takes” to ensure it never to return, the very action of QE reduces the likelihood of governments undertaking the reforms Draghi so repeatedly calls on them to take.
The opinions expressed are those of Jeffrey Rosenberg as of 1/23/2014 and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of any individual holdings or market sectors.
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