Bonds on board QE train, euro under the tracks

Mario Draghi, president of the European Central Bank (ECB), reacts whilst speaking during a news conference where he unveiled historic measures to face down inflation, in Frankfurt, Germany, on Thursday, June 5, 2014. Draghi unveiled an unprecedented round of measures to help the ECB's record-low interest rates feed through to an economy threatened by deflation. Photographer: Martin Leissl/Bloomberg *** Local Caption *** Mario Draghi

Mario Draghi, president of the European Central Bank (ECB), reacts whilst speaking during a news conference where he unveiled historic measures to face down inflation, in Frankfurt, Germany, on Thursday, June 5, 2014. Draghi unveiled an unprecedented round of measures to help the ECB's record-low interest rates feed through to an economy threatened by deflation. Photographer: Martin Leissl/Bloomberg *** Local Caption *** Mario Draghi

Published Jan 28, 2015

Share

THE EUROPEAN Central Bank’s (ECB) plan to purchase at least e1 trillion (about R13 trillion) in bonds, referred to as quantitative easing (QE), represents a big leap forward. I think it is a sizable amount of money. The plan demonstrates that the ECB not only talks, it also acts, which is important for market psychology.

The plan should have a modest impact on the ECB’s goals of weakening the euro exchange rate and making it easier for businesses and consumers to borrow money, which, in turn, may stimulate growth.

It should also provide an accommodative backdrop for countries that are implementing necessary structural reforms, which are critical to the long-term recovery of the euro zone.

What I find unusual is that only 20 percent of the e1 trillion in bond purchases, or e60 billion a month through at least September 2016, will be risk-shared across all of the euro zone. It will be up to the individual national central banks to purchase the remaining 80 percent, and those countries will be responsible for the risks involved with holding those assets.

It would’ve been better if the plan had called for the assets to be 100 percent risk-shared, and that the securities were held directly on the ECB’s balance sheet. That way, any losses – or gains – would be spread out among constituents. However, that provision of the plan should not significantly impact the central banks because they have the ability to hold securities, even if the securities are trading at a loss, until maturity.

Such issues make the ECB’s plan a little more complicated than the QE programmes we’ve seen in the US or the UK. When multiple countries work together, as is the case in the euro zone, it does take time to sort things out.

Another difference between the ECB’s QE plan and those of the US and UK is its size. While e1 trillion represents a very good-sized programme – better than many people expected – it is quite a modest plan in comparison to those of the US or UK.

Market outlook

Assets eligible for purchase in the ECB’s e1 trillion programme are government, agency and supernational bonds that are domiciled in the euro zone.

Bonds with negative yields can also be considered for purchase, according to ECB president Mario Draghi. His admission was surprising since the ECB previously said it would not buy negative-yielding bonds. The UK and the US never bought bonds with negative yields. I think this change of heart shows how committed the ECB is to making its QE programme work.

While not part of the ECB’s asset-purchase plan, corporate debt may still do well on the back of the programme. I think there will probably be a moving out on the risk spectrum as the ECB buys government bonds, and investors then have to find something else to own to get yields. It’s likely that investors will head into corporates, and that may result in corporate spreads continuing to decline.

Additionally, with the launch of the QE plan, the ECB has re-emphasised that it is there to inject as much liquidity into the market as possible. That means European bonds are potentially positioned to perform well because the ECB is on a heavy easing cycle, compared with other countries where there is talk that rates will rise (namely the US). Overall, I don’t think QE will be good for the euro, which will probably lose value in the wake of this plan over time.

Finally, the Swiss National Bank’s (SNB) abandonment of its currency cap, which had pinned the currency at Sf1.20 (R15.46) per euro, caused a significant drop in the euro versus the Swiss franc.

I think the SNB realised that if a large QE programme was coming from the ECB, it would have to buy too many assets to maintain the cap. Instead, it decided to move before the QE, so the Swiss could deal with their economy’s issues on their own terms. However, this pre-emptive move has cost the SNB some credibility, because bank officials have said that the currency cap was one of the key pillars of their system. It obviously wasn’t. It also means that there will probably be an ever-increasing deflationary pressure in Switzerland, which they will have to try to deal with on their own terms.

David Zahn is the head of European fixed income at Franklin Templeton Investments.

Related Topics: