Posted April 21, 2015 Hector Ketley
As Draghi announced the ECB’s rate decision on January 22nd at 12:45, traders the world over were left unsurprised by both the decision to hold all three key rates, and that there would be some further monetary policy measures discussed at the 13:30 press conference to combat the Eurozone inflation rate of -0.2%.
This hint was aimed at the universally anticipated QE measures which had been a hot topic in business news. This is a conceptually simple programme where money is electronically printed and used to buy up bonds in the Eurozone. There are two primary ways in which this action can help to reinvigorate a stalling Eurozone: currency depreciation and liquidity easing. These act to make goods produced in the Eurozone more competitive in the global economy and free up capital in commercial institutions so that credit can be lent more readily. Intra-EU trade accounts for between 60% and 65% of the total so the remaining 35% to 40% is boosted by a devalued currency, but the liquidity benefits can be far greater; cheap and accessible credit is the grease necessary for a smoothly running economy. It increases the opportunity cost of investment and consumption expenditure which are by far the greatest components of the Eurozone’s income.
The wait for clarification of the details had formed a clear division in people’s faith in such a programme. A general consensus from analysts and economists alike was that, if an electronic money printing programme were to be acceptable to markets and have a shot at working, then it would have to be big. Very big. In addition to the size of the programme, there were several features to the QE programme that traders were seeking confirmation of. Namely: risk-sharing between nations, the credit rating criteria of the debt, and whether the programme would be limited to sovereign bonds or extended as far as agency bonds or even corporate bonds.
In this case, Draghi’s reputation as one to over-promise and under-deliver was unjust as the details of all aspects of the programme were at the top end of market expectations. In terms of size, market expectations were between 500bn and 1tn Euros but 18 monthly purchase targets of 60bn Euros amounts to just shy of 1.1tn. Furthermore, the plan was declared “open-ended,” meaning that 18 months was a guideline but the programme could continue longer, or finish earlier, as is necessary to observe a “sustained adjustment in the path of inflation” to its target levels of close to but less than 2%. Sub-investment grade bonds are to be included although Greek bonds cannot start to be bought before July. National Central Banks are to bear 80% of the risk of purchases rather than the ECB bearing all risk centrally and this will be deemed much fairer on Germany and other fiscally responsible nations.
As this is a bond-buying programme, investors have been transferring their wealth into bonds knowing that they will have a willing purchaser in the form of a central institution. This has pushed the prices of the bonds up to the point where many bonds are offering negative yields and Draghi has expressed a willingness to buy bonds with negative yields.
Of particular interest to people both inside the industry and out is which markets will be affected by a QE programme, and how those markets will respond. People often poke fun at the work of economists in their field of the “dismal science,” but given the central importance of a global marcoeconomy on market participants profits, vast resources are committed to their work. This means that the QE programme was fully expected, and markets could be seen to gradually price it in, particularly through the Euro depreciating against the US Dollar and European equities and bond prices climbing. The possibility of one happening have probably been priced in for a while but the aforementioned measurable pricing in observed in forex, equity, and bond markets was largely in response to three major news items in the run up to the announcement: First, the ECJ had ruled in favour of the ECB, much to the upset of the Germans, that a bond-buying programme of this sort was not unlawful. Second, the SNB had pre-emptively abandoned its currency peg. Third, the Danish central bank cut rates three weeks after the SNB’s major move.
The move by the SNB was arguably the primary signal that the QE programme was only a matter of weeks away. To indicate how certain the SNB must have been about this, we must look to the consequences of scrapping the exchange rate ceiling – the Franc jumped 30% against the Euro in a matter of minutes (a change of 2% over a day is considered extreme in Forex markets), the Swiss stock market had 9% of its capitalisation wiped out in a day as the goods of it’s constituents became drastically less competitive abroad, and spread-betting companies realised losses large enough to force them into liquidation with many of their clients losing at least the entirety of their aggregated trading profits.
Now that the QE programme is fully underway, there are sceptics who say that whatever the theoretical benefits, the programme may not be accomplishable. This is based on the fact that it may not actually be easy for the National Central Banks to find sellers of bonds. New regulation aimed at banks and pension funds holding a greater weighting in low risk and liquid assets means that even if a financial intermediary has a great bond holding, they may be restricted from selling enough of them to meet the ECB targets. Households and companies own a market share great enough to cover the entire purchase target, but it is not practical to trade with all of them as many thousand sellers would need to be contacted.
The two major sources of hope are investment funds and non-Eurozone holders. An investment fund can plausibly be willing to sell of its Eurozone bonds and place their wealth into government bonds from other major economies like the UK or USA, or corporate bonds, but to what extent is subject to their individual constitutions. Purchasing bonds from non-Eurozone holders may be seen as being a bit self-defeating – if a significant proportion of the bonds are purchased from foreign holders, then the liquidity easing effect will undoubtedly be reduced because Eurozoners will still be holding bonds and not cash. We would still expect to see some credit easing resulting from the lower borrowing costs arising from the purchasing, however.
Whether by coincidence or cunning, Draghi’s declaration of an open-ended programme may provide a justification to miss monthly targets but extend the programme to minimise distortions. But one can only speculate on this until target dates are reached. So far, the programme is on track but as each bond is bought, one fewer exists to be bought and there is every possibility that the easier bonds to buy are being cherry-picked and this purchase ease will diminish.
A real source of optimism can be found in the timing of the programme. Eurozone unemployment has fallen, deflation was lower than expected for February,Markit’s March composite Manufacturing PMI is at a one-year high, and stock indices are reaching new highs. Other measures for consumer confidence and business sentiment are mixed but undoubtedly improving. If we think that the main reason that QE did not work in the USA was that banks were not willing to lend on their newly acquired cash due to bad and worsening economic conditions, then we can say that this QE programme has a better shot at working as we face less bad and improving economic conditions. Some do not believe that the QE programme will act as a catalyst to economic recovery as the size as a proportion of GDP is only half the size of the UK and American programmes but as we all know, it’s not how big it is, it’s how you use it and markets are responding positively to the details of Draghi’s QE so far.
The last element to consider in whether to believe in this QE is the future of Greece. The effects of a ‘Grexit’ or ‘Grexident’ would totally outweigh QE and the contagion resulting from a default on Greek debt would certainly at least undo the progress towards recovery over the last years; credit would dry right up and a huge total value of assets would disappear. The prosperity of Greece is paramount in determining whether this QE programme will work.
But this worst-case scenario is highly unlikely as all parties involved are committed to avoiding it. EC president Juncker said, “I’m totally excluding a failure. I don’t want a failure. I would like Europeans to go together. This is not a time for division. This is a time for coming together.” Varoufakis has reiterated that he does not want Greece to default on its debts and has never indicated that this was the case. Draghi has extended Greece’s Emergency Liquidity Assistance by €500mn, €600mn, and €400mn on March 5th, March 12th, and March 19th, respectively, amounting to a total sum to date of about €70bn. He has shown a real determination in supporting Greece but has shut down any ideas of an increased limit for T-bill issuance as this would amount to illegal monetary financing – a persistent, supportive, and responsible/legal aid programme.
Further, despite talk of Greece’s coffers running near empty, the underlying state of Greece’s public finances is not as bad as many suspect. Greece has large amounts spare capacity. After it’s 25% contraction over the last five years, the readiness with which the Greek economy can kick-start its recovery will be largely dependent on productive potential. When an economy contracts and its production is lowered, how quickly it can return to growth will depend on whether its capacity is there and waiting to be re-employed, or has been destroyed. OECD figures suggest that the former is the case for Greece.
To apportion credit to whom it is due, Varoufakis must be said to be doing a fantastic job. He is effectively acting as intermediary to Tsipras and the Germans. The Germans want stringence in extending further loans to Greece feeling that they are carrying them. Meanwhile, Tsipras, who was elected on the back of ludicrous false promises and popularist hope inspiration, demands a lot more from the ECB than they feel comfortable giving and has been struggling to meet his promises.
But while the Greek people can have confidence in their representation through Varoufakis, Tsipras needs accept that blame lies with previous Greek governments who, in the words of Krugman, “behaved irresponsibly, lied about it, and got caught.” This refers to the conservative government jumping on the chance of cheaper debt once the Euro was launched, ‘rounding down’ how much they were borrowing, and then being exposed when a new government was elected in 2009. Further, where tax evasion amounts to about €30bn per year and is such a phenomenon that politicians have called it a national sport and political corruption is rife, structural reform must take priority. It must even take priority over the cutting of market deregulation and social welfare reform – what good is a slightly better functioning market place to the Greek government if they cannot collect on it? Not only is Tsipras not able to reinstate the public sector workers like he promised, a shrinking tax base makes it increasingly difficult to pay the existing ones.
Although the outlook for Greece seems grim, traders should not fear Greece leaving the Euro. Despite many feeling that Greece cannot meet its debt obligations, it has done so against the odds so far and continuing to do so will be all that it takes for Greece to continue being cast a lifeline of credit. If this is considered alongside a promising QE programme received positively in markets, then there is hope for a once more prospering Eurozone thanks to Draghi.