Euro-zone: What comes after QE?
The euro-zone is on an exit route from quantitative easing
• The European Central Bank has announced that it will end its asset purchase programme at the end of 2018
• Investors are less concerned with default than they were at the height of the euro-zone crisis
• Italy’s political crisis caused a dramatic increase in spreads
• Forward guidance could replace QE as the central bank’s favoured policy
The euro-zone, like the US, is transitioning towards a normalisation of interest rates after the implementation of quantitative easing (QE) as a response to the global financial crisis. That should be a relief, given the huge distortions that QE has created in the global economy, most notably in asset price inflation and a consequent widening of inequality throughout the developed world.
The political implications have been obvious and are still continuing. But how quickly and safely central banks can be weaned off this great monetary experiment remains to be seen.
The European Central Bank (ECB) has announced that it will wind-up its Asset Purchase Programme (APP) by the close of 2018. At the end of September the monthly pace of net purchases will fall from €30bn to €15bn until the end of December when they will finish.
In other respects the policy of monetary accommodation will continue for a while longer. The practice of reinvesting principal payments for maturing securities purchased under the APP will continue for an extended period. In addition, the key ECB interest rates will remain unchanged at their present low levels at least until the summer of 2019.
To understand the shift in bond yields it is necessary to separate the impact of the existing stock bought by the ECB from the impact of future flows. Pieter Jansen, a senior strategist at NN Investment Partners (NNIP), says research shows convincingly that the stock of bonds purchased has had more impact on the level of bond yields and the term premium than the flow. But as the flow of new purchases dries up it will take some time for the stock to be adjusted, even after the cessation of reinvestment of coupons and principal. “The rules for government debt and deficits don’t allow for a significant change in the supply of government bonds,” says Richard Ford, head of European fixed income at Morgan Stanley Investment Management.
Today, in contrast with the height of the euro-zone crisis from 2011-14, investors are less concerned with default. The situation in most of Europe also looks fundamentally different from a year ago, when there seemed a high chance of populist politicians being elected with anti-EU agendas in countries such as France and the Netherlands. “You don’t have euro break-up scenarios any more. The focus now is on the long-term debt sustainability and debt stability,” says Jonathan Baltora, senior portfolio manager at AXA Investment Managers.
Spreads in the Netherlands, Austria and Germany are at their tightest levels since the euro-zone crisis. The countries are seeing strong GDP growth and falling budget deficits. Germany has been shrinking the size of issuance, so less bonds are available. “When you look across the euro-zone, the differentiating factor is growth,” Baltora says. “When you see growth, you have debt stability. Where you don’t see growth, debt stability is questionable and you need fiscal policies that ensure debt/GDP ratios do not increase”.
Spain and Portugal have had reasonable growth for some time. This is apparent in the fiscal balance and the beginnings of the reduction of debt to GDP ratios.
Spreads in Italy have been widening this year since the election results, and the political crisis in May caused a dramatic increase. But in Italy, the key issue is still political. “The new coalition could derail the reforms that have been put in place that are important drivers to boosting productivity growth in Italy,” said Isabelle Vic-Philippe, head of government bonds at Amundi , prior to the crisis in May. That Italy finds it difficult to establish stable government is clearly an issue that differentiates the country from others within the euro-zone and the market has recognised this in Italian bond spreads.
But Vic-Philippe sees the financial markets as complacent, with the view that Italy will continue within the euro-zone like any other country, although growth may be slower. That is quite positive but, as she adds, if there is a risk of backtracking on reforms or increasing spending, then Italians bonds will be repriced as the market reacts. “No one seems to know what a populist government is likely to do. The two coalition parties are very different to each other, but the market seems to be assuming they will find agreement and there will be no change on the economic front so investors can be relaxed,” she says. But if owning Italian government bonds holds risk, being underweight against a benchmark is expensive, given their spread.
At some point, the ECB needs to decide that the euro-zone economy is operating at a normal level. Ford argues that as the ECB has an inflation target of 2%, “normality” must mean inflation close to that level.
Given that the justification for QE in the first place was that inflation was below 2%, normality requires inflation to be higher and a demonstration that the underlying economy is showing growth in the region of 2%. But, points out Ford, the demographics for developed markets are changing and it is not clear that the old levels for inflation and growth with a different demographic mix would be the ‘normal’ levels today. Ageing populations would be expected to give rise to lower growth and lower inflation. There is also a shifting economic balance towards services at the expense of manufacturing, giving rise to a lower multiplier effect and that would also lead to a different level of normality than in the past.
“Will they be so aggressive about keeping the 2% inflation target?”
If the economy reaches normality, however defined, should that trigger a change in the size of the balance sheet? Ford says: “I think it will be discussed, but we don’t have any clear playbook as to how the ECB will respond, although the evidence from the US appears to be that the direction of travel is to reduce the size of the balance sheet as that gives policy flexibility in the future.” If the US is successful, that will provide a policy framework for the ECB.
If QE is no longer an active policy instrument what will replace it? Jansen says forward guidance on rates will become the policy instrument with which the ECB reacts to changes in the outlook. “There is a potential credibility problem here because the ECB tied the continuation of QE explicitly to progress towards price stability.”
An important issue that Ford raises is the succession policy for the ECB: “That matters because one issue is whether the next generation will stick to the same policy mix – will they be so aggressive about keeping the 2% inflation target, for example?” Choosing the composition of the ECB, especially the next head will become a political battleground, with Germany’s chancellor Angela Merkel in particular, having to make compromises between issues such as monetary policy and the long-term future of the whole European project. For the euro-zone bond markets, it looks as though politics will be more important than economics, and for fund managers, that plays to their strengths.