By Stephanie Flanders, Chief Market Strategist, UK and Europe, JP Morgan Funds
The ECB’s QE announcement last week is the latest in some new positives for Europe. Markets needed to hear that the ECB was both willing and institutionally able to pursue its inflation target, however tortuous the path to that objective might be, and that’s what they got.
We’re hopeful this could be the start of a positive period for the eurozone economy, thanks to less austerity, steady economic reforms, a turn in the credit cycle, a more pro-active central bank and a falling euro.
Clearly the ECB announcement in and of itself is not the solution to Europe’s many economic problems. But it should put further downward pressure on sovereign bond yields in Europe and globally and contribute to an improving backdrop for Europe’s economy and markets
Quantifying European QE
The new programme of quantitative easing will involve the national central banks of the Eurozone purchasing €60bn in investment grade Euro-denominated sovereign and corporate bonds every month, starting in March and continuing until at least September 2016.
These purchases will total no less than €1.1trn and would represent a more than 50% rise in the size of the ECB’s balance sheet by the fall of 2016 (see chart). There is an open-ended character to the programme because Mario Draghi said the purchases would continue until it sees a “sustained adjustment” in inflation consistent with achieving the central bank target of “below, but close to, 2% over the medium term.”
The bond purchases will represent a major increase in demand for these assets in 2015. Though the ECB has limited itself to buying no more than a third of the outstanding sovereign debt of a single country, its purchases will be the equivalent of more than 45% of total sovereign new issuance within the eurozone in 2015.
For investors, these details were important. But not nearly as important as the overall message.
ECB President Mario Draghi started to prepare the groundwork for QE in his speech at Jackson Hole in the summer of 2014. When the eurozone fell into formal deflation – falling prices – in December, some action from the central bank in January seemed all but inevitable.
So this did not come as a complete surprise. In fact the growing expectation of QE had already done some good work for the eurozone recovery by significantly weakening the value of the Euro and making European exporters more competitive. The most basic test that the ECB’s governing council needed to pass was to do no harm to that good work. A tougher test was to surpass market expectations, further pushing down both the euro and borrowing costs for the periphery countries.
So far, the ECB’s recent action passed both tests: the euro fell to an 11-year low against the US dollar on the day that QE was announced, market inflation expectations fell across the board and bond and equity markets rose, holding on to these gains despite the drama of the Greek election.
Real borrowing costs in the eurozone are already among the lowest in the developed world. So there is less room for QE to be a “game changer” now than in these previous episodes. But if anything, the need for ECB action is even greater than it was when other central banks resorted to QE.
Long-term inflation expectations in the eurozone are now the lowest in the developed world. If the forward market is anything to go by, investors do not expect the ECB to get inflation close to 2% in the next five years – or even, maybe, the five years after that.
Lower oil prices are partly to blame for the continued fall in the inflation numbers. But there is a major upside to cheap energy for European consumers. The latest ECB survey of credit conditions also a showed a marked improvement in credit demand in the region. These factors, combined with the extra impetus from a cheaper Euro provide a more favourable environment for QE to work than would have been the case six months ago, when the policy was first seriously discussed. Hopefully, this will all feed through to higher corporate earnings over time.
So yes, there are still serious headwinds for the European economy – particularly on the political front. And yes, there is still a long way to go if the ECB is going to meet its newly restated inflation goals. But the announcement of eurozone-style QE has taken it several steps in the right direction.
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