Quantitative Easing Improves Prospects for the Eurozone
The ECB announced a new program of asset purchases. Both the size and pace of purchases are at the upper end of expectations. Together with other policy actions that are underway, the program will strengthen the cohesion and economic recovery of the Eurozone.
After months of internal wrangling, the European Central Bank (ECB) finally announced that it would start to buy government bonds. The ECB had already begun to buy private sector covered bonds and asset-backed securities in Q4 2014, but these markets are clearly too small to allow the ECB to boost its balance sheet by the targeted EUR 1 trillion. The ECB's program of so-called targeted long-term refinancing operations (TLTROs), i.e. cheap loans from the ECB to commercial banks, disappointed as well. So far, the TLTROs have been used, if at all, to replace previous ECB loans. Moreover, commercial banks in Northern Europe have little interest in the program because they can now borrow almost as cheaply in the market. Conversely, the weakness in demand for corporate credit in the Eurozone "periphery" limits these countries' banks' need for the ECB loans.
A larger program than expected...
The details of the ECB program are fairly complex because of the complicated structure of the Eurozone's system of central banks and because political compromises had to be made, but overall the quantitative easing (QE) program looks like a potentially powerful one to us. Its key features are:
- Starting in March 2015, the ECB intends to buy EUR 60 bn of assets per month until at least September 2016. This would amount to approximately EUR 1140 bn for the total program, slightly above expectations. We estimate that about EUR 40 bn per month could flow into sovereign bonds, which approximates to total sovereign bond purchases of about EUR 760 bn, also above market expectations; the latter had ranged between EUR 500 bn and 700 bn. The intended length of the program is also somewhat greater than expected. Moreover, the ECB indicated that QE could be extended beyond 2016 if it is necessary to bring inflation back on track toward the 2 percent target
- Purchases across markets will be allocated according to the capital shares which the national central banks hold in the ECB (capital key). This means that the Bundesbank, for instance, will buy a larger amount of bonds than the Banca d'Italia. Purchases will be undertaken by the national central banks, which are members of the Eurosystem.
- Generally, purchases will be limited to 25 percent of the outstanding debt of a particular issuance and 33 percent of particular issuer. Purchases will be made along a maturity range of 2–30 years.
- Apart from sovereign bonds, the national central banks can also buy bonds from supranational institutions or agencies. While this is less important, it still amounts to 12 percent of the additional purchases.
- There had been some discussion regarding the creditor status of the ECB relative to other holders of government bonds. The ECB has confirmed, however, that it will not have senior status. This is important because it prevents the credit quality of debt held by private investors from worsening as the ECB accumulates bonds.
- As expected, Greek bonds are excluded for the time being from the QE program because their credit quality is insufficient. Countries under an adjustment program will have to fulfill specific criteria.
- Apart from the purchase program, the ECB also reduced the interest rate charged on the targeted longer-term refinancing operations (TLTRO) by 10 basis points, effectively setting it equal to the main refinancing rate of 0.05 percent.
Oustanding amounts (principal only) of privately held public debt (central government and other)
(Bloomberg, Datastream, Credit Suisse)
|Country||Rating Moody's/ S&P/Fitch||Total (EUR bn)||Available for purchase (25% of outstanding debt, EUR bn)|
...with limited, politically motivated drawbacks
The only feature of the QE program which had raised discussions regarding its robustness over the past week is the issue of so-called risk-sharing. Germany, in particular, had insisted that national central banks need to bear the risk of potential losses on their respective government's bonds. The argument was that QE would otherwise breach the "no-bailout" clause. In reality, we do not think, however, that this feature seriously undermines the effectiveness of QE, as there are other mechanisms which reduce the risk of government default. First, the European Stability Mechanism (ESM) can act as backstop to governments and banks under a potential support program; second, the ECB could, in principle, support individual governments, since the European Court of Justice recently indicated conditional support programs (OMT) as legal; third, the TARGET2 system, which effectively allows central banks in EMU member states to borrow to an almost unlimited extent from each other, is a further key backstop.
Why the QE program should be effective
Various observers have argued that QE would not work in the Eurozone, in contrast to the USA or UK. We disagree. First, although bond yields in the Eurozone periphery have declined markedly, we think they could decline even further, and thereby lower overall borrowing costs. Second, by buying government bonds from banks and other investors, the latter should be enticed to invest elsewhere (i.e. bank lending should also be enhanced). Third, bond purchases will not only support bond prices, but also translate into increases in other asset prices. This should, for example, make it more attractive for companies to raise equity capital, and it implies positive wealth effects for households. Real estate prices will likely also be supported. Finally, QE, which will expand the ECB's balance sheet while other central banks, notably the Fed and the Bank of England, have halted their asset purchases, should weaken the euro, and thereby stimulate the competitiveness of Eurozone companies. Possibly of greatest importance, in our view, could be the effect on the confidence of European businesses and consumers. The launch of the QE program is a powerful signal that the Eurozone will indeed stay intact and that policymakers are finally doing "what is needed" to boost growth.
A better policy framework in place
Overall, we think QE adds another piece of the puzzle to an improving policy framework in the Eurozone. Fiscal consolidation has come a long way, even if actual deficits are still high due to the weak cyclical situation. This will allow governments to ease off further from austerity measures. Second, the European Banking Union has been launched, which reduces financial risks and may improve financial market integration. Efforts to move to a Capital Markets Union may gather steam as well; QE should, in any case, reduce the perceived risks of cross-border investment. Finally, structural reforms continue to be implemented in all the Eurozone economies, including Italy and France, albeit hesitantly. Overall, this strengthens our view that the Eurozone will gradually emerge from stagnation, and that we may even see upside economic surprises.
Main market implications
While our asset class experts will provide more details on the financial market and investment strategy implications of QE, we believe that it has essentially three impacts: first, QE will generally keep bond yields low for long, and to the extent that QE lowers default risks in the Eurozone, spreads of peripheral bonds should also stay tight. While overall expected returns are very low in most bond markets, the risk of major setbacks is therefore limited. That said, like in the case of the USA, our strategists expect longer-dated bonds, especially in Germany, to weaken somewhat as QE is actually launched ("buy the rumor, sell the fact"). Second, QE should further weaken the EUR against other major currencies. Third, Eurozone equities should be supported by better growth and thus earnings prospects, low interest rates and a weaker EUR.
On a sectoral basis, banks should benefit from QE as better domestic growth stimulates lending and reduces loan losses. Further beneficiaries are European exporters which will profit from a weaker EUR. Prime examples include the German automobile industry, which produces high-end cars exclusively in Germany and exports them all over the world.
ECB QE is a mixed blessing for Switzerland
For Switzerland, QE is a mixed blessing. While the expected improvement in economic activity should be supportive, the risk is that the CHF stays very strong against the EUR or even appreciates further, at least temporarily. This would weaken exports and slow the economy. Finally, the implication of continued CHF strength is that negative inflation will persist in Switzerland. For the Swiss National Bank, this may well imply that it needs to intervene more heavily than expected in the foreign exchange markets to prevent excessive CHF appreciation (in contrast to what was hoped for as the lower EUR bound was abandoned), or that interest rates will need to be lowered even further.