News In Charts: ECB Joins The QE Party, While Promising Not To Drink Too Much

With a delay of around six years, the ECB has finally turned up at the QE party. We have long predicted that it would, albeit with faltering confidence. From March 2015, the ECB, together with the National Central Banks, will purchase a mix of public and private sector debt at a rate of €60 billion per month. The Expanded Asset Purchase Programme (EAPP) is intended to last until September 2016, suggesting a total size of €1080 billion. This was very much at the upper end of expectations, and has generated some excitement. Twenty-four hours after the announcement, the euro is down by more than 3% against the US dollar, while broad-based European equity indices are up some 4% in local currency terms. Sovereign yields are down across the board. At the time of writing, ten-year Bunds are yielding less than 0.4%. And the yield on ten-year Greek government bonds has fallen by some 80 basis points.

To our mind, a number of issues around the mechanics of the scheme remain unresolved. Much attention has focused on the issue of debt mutualisation. Following a series of carefully timed leaks to the press, many feared that all of the purchases would be carried out by the National Central Banks, with any losses made good by the relevant sovereign. Yesterday we learnt that 80% of purchases would fall into this category, with all member states jointly liable for the remaining 20% according to the capital key – a sort of ‘not-quite-halfway’ house, if you will.

The issue of who carries the can if the purchases turn sour is an important one. Imagine for a moment that this scheme had been in place before Greece got into serious trouble through the summer of 2010, and that the Greek national bank (BoG) had bought a large quantity of Greek government bonds before Greek government yields began to rise. In the wake of the Greek default, it is ultimately the Greek sovereign that, under the EAPP, would have been responsible for making good on the loss suffered by the BoG. Does that mean the Greek sovereign would be required to recapitalise the BoG? We cannot be sure, since many central banks can legally operate with negative equity and are protected from insolvency proceedings. However, one or two governments within the single currency bloc would presumably be happy with that interpretation. In his opening statement yesterday, Mr Draghi described losses by the programme as merely ‘hypothetical’. But euro area government bonds have fallen in value before, dramatically on occasion! If a defaulting sovereign is required to recapitalise losses at its own central bank, then that surely weakens, rather than strengthens its position?

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As recently as last October, and in reference to the European bank stress tests, ECB Vice President Constancio declared, “The scenario of deflation is not there because we don’t consider that deflation is going to happen”. Two months later, the region as a whole was in outright deflation, together with twelve of its nineteen members. We have long written that Italian debt, as a proportion of GDP, would rise without bound if Italian inflation were to turn out in line with breakeven rates implied by a comparison of the yield on conventional and index-linked BTPs. But, on the eve of January’s policy meeting, it was not just Italy that was in trouble. French five-year breakevens were approaching 0.5%, while German five-year breakevens were hovering around zero. At these rates of inflation, neither the German nor the French government finances would be on a stable footing. It was perhaps a recognition that Italy was no longer the only elephant in the room that finally triggered a response.

Given China’s ongoing economic slowdown, and all its attendant consequences, including a 60% drop in the price of oil, and the risk that China begins to export deflation on a massive scale, the EAPP needs to deliver a material depreciation of the euro. The movement in the first twenty-four hours has been impressive, and it is certainly in the right direction, but it is not enough. In our view we would need to see, in a short space of time, an effective depreciation in excess of 20% from the levels seen on the eve of the announcement.

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What of asset prices? The response of equity prices to date has been impressive, though it will undoubtedly take time for markets to digest some of the finer detail, and reach a definitive conclusion on the merits or otherwise of the programme. What can we learn from the QE programmes of both the US and the UK? We choose here to focus on extensions to the programmes, rather than the initial launch of QE by each central bank, simply because, back in early 2009, equity markets were in a state of panic, and the global outlook was desperately bleak. It is widely accepted that phase one of QE put a floor under equity prices, and restored at least a degree of calm. Our final chart shows movements in the S&P500, and in the FTSE100, in the 30 days before and the 30 days after extensions to the US and UK schemes. In each case, over the next 30 days, equities rallied by between 5% and 10%.

Our view is that the EAPP changes nothing fundamentally. Although statements to date are deliberately vague, we cannot see how the EAPP puts in place the framework for fiscal transfers that the euro area so sorely needs. We believe that the EAPP is probably enough to lock-in the gains in euro area bonds and equities that have occurred since Draghi’s ‘whatever it takes’ speech. There is some upside risk, though in our view it is modest.

Fathom will be presenting its latest assessment of the global economic outlook at an event to be held at the Thomson Reuters offices in London on Friday 6 February. This will be followed by a panel discussion. Readers who may be interested in attending should contact tessa.thier@fathom-consulting.com

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.

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