Will the ECB’s QE bazooka send European stocks higher?

Yes

Richard Duncan, Economist Macro Watch

The European Central Bank (ECB) unveiled a monetary bazooka at its press conference on 22 January by announcing it will begin buying €60bn worth of bonds every month from March 2015 to September 2016 – or even longer if necessary to push inflation expectations back toward its 2 per cent target. This launch of ECB Quantitative Easing (ECB QE) is a very important development that is likely to push European stockmarkets significantly higher. It may also revive Europe’s weak economy, at least temporarily over the next couple of years. 

Here is how the ECB expects this policy to work. First, it will cause the euro to depreciate against the US dollar. In fact, the euro has already fallen by 16 per cent against the dollar as investors were led to anticipate this development over the last six months. The lower euro will boost industrial production in Europe by making European products less expensive outside Europe, thereby boosting exports, and by making goods made outside Europe more expensive, thereby deterring imports. Similarly, the weaker euro will attract many more tourists to Europe, while discouraging Europeans from travelling abroad. 

Next, when the ECB buys €60bn worth of bonds each month, it will push up the price of those bonds and thereby push down their yields. This will push down interest rates not only on government bonds, but also on corporate bonds and mortgages, which should encourage more borrowing, investing and home buying. 

Third, as the ECB buys €60bn worth of bonds each month, whomever they buy the bonds from will have €60bn in cash that they will have to invest in other euro-denominated assets such as stocks. That means stock prices are likely to rise, making investors “wealthier”, thereby allowing them to consume more. Higher consumption will mean more economic growth. Central bankers refer to this process as “portfolio rebalancing”, leading to a positive “wealth effect”.

Make no mistake, the creation and investment of €60bn a month (€1.1tn over 19 months) is a very big deal. The yields on European government debt have already collapsed to new historic lows over the last few weeks even before the programme’s implementation begins. The yield on 10-year German government bonds fell to 0.27 per cent on 30 January, lower, astonishingly, than even the 0.3 per cent offered on 10-year Japanese government bonds. Even the yields on 10-year government bonds in Spain and Italy, where government finances are considered to be weak, fell to only 1.45 per cent and 1.58 per cent, respectively. 

Such ultra low returns on “risk free” government bonds will force investors to move into riskier assets in search of higher income. That move will make more money available for riskier investments, which could boost economic growth. The problem with this, of course, is that many of those riskier investments are likely to fail. When they do, instead of providing investors with a higher return, they will destroy the capital invested. 

As in the United States, credit growth drove economic growth in Europe for decades until 2008 when it stopped expanding. The success of ECB QE over the longer run, therefore, will depend on whether it causes credit in Europe to begin growing again. 

Unfortunately, the prospects of that occurring are less than promising. The level of credit (i.e. debt) is already too high relative to income in Europe – just as it is everywhere else in the world. Always remember, the crisis in the global economy boils down to just one thing: globally, there is too much debt relative to income. This crisis will not end until the wages of the middle and lower income groups begin to increase again.

No

Raoul Ruparel, Head of Economic Research, Open Europe

Raoul Ruparel, Open Europe

The eurozone is not the US or UK. It’s so obvious that it should go without saying. But when it comes to assessing the potential effectiveness of QE, people tend to overlook the obvious. 

When the US and UK implemented QE, their 10 year borrowing costs were above 4 per cent and 3.5 per cent respectively. Currently, the eurozone’s is around 1.5 per cent. Over the past two years borrowing costs have plummeted across the eurozone. It is in a fundamentally different place to the US and UK when they launched QE, so drawing any correlation in potential results is unfounded. Furthermore, given where yields are, the added benefit of marginally pushing them down further is far from clear. Let’s not forget that accompanying this huge reduction in yields over the past few years has been a vast economic malaise. Growth has faltered, unemployment grown and money continues to struggle to flow into the real economy.

The reasons behind this remain pertinent. They explain why the vast liquidity injected via QE could (as with previous liquidity injections) fail to be transmitted to the real economy.

Firstly, in the eurozone, non-financial corporations still get 85 per cent of the funding through the banking sector. Even if QE succeeds in stimulating capital markets, the avenues for this to filter through to the real economy do not exist at the same level as elsewhere. Throwing copious amounts of liquidity at the banks – as with the long term refinancing operations – has failed because they continue to try to de-risk, recapitalise and consolidate. Furthermore, they just do not fancy lending into complex jurisdictions with poor growth prospects.

Secondly, while senior ECB officials speak optimistically about the “portfolio rebalancing channel”, they will be fighting the tide. The sovereign debt market is many orders of magnitudes larger than the corporate bond market in the eurozone. The rebalancing from one to the other is a challenge. There are long-established reasons why institutional investors in the eurozone hold 48 per cent of assets in sovereign bonds and only 7 per cent in corporate bonds – regulation and risk controls being chief among them, neither of which the ECB can change.

The way the programme is structured means a significant amount of funding will flow into Germany and the core countries – where liquidity is already abundant. This is an inevitable side effect of the set-up of the eurozone but means money is unlikely to get where it is most needed. 

Finally, when it comes to size, the ECB may have delivered above expectations but the overall programme will still purchase 17.5 per cent of the eurozone sovereign debt market compared to 27.5 per cent and 21 per cent in the UK and US respectively.

ECB QE will probably have some success in pushing down sovereign yields and buoying equity markets. But to what end? Bond and stockmarkets have rallied for the past two years. The eurozone economy looks as bad as ever. Lending to the real economy continues to contract. The failure to fundamentally reform institutions and structures of the eurozone as well as tackling on-going concerns around the banking sector and the wider business climate means ECB QE will likely be ineffective as with previous ECB action. After all, QE is just a larger version of what has already been done. It does not fundamentally change the game and will not fundamentally change the long-term problems plaguing the eurozone economy.