Europe’s Quan­ti­ta­tive Teas­ing

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On Wed­nes­day, the eu­ro­zone is likely to inch a step closer to quan­ti­ta­tive eas­ing when the Euro­pean Court of Jus­tice hands down its pre­lim­i­nary rul­ing on the le­gal­ity of the Euro­pean Cen­tral Bank’s pro­gramme of Out­right Mon­e­tary Trans­ac­tions pro­posed in 2012. While the ECJ is ex­pected to find that the OMT lies within the ECB’s com­pe­tence (to use Euro-jar­gon), any qual­i­fi­ca­tions it makes will go a long way to de­ter­mine the shape of a eu­ro­zone QE pro­gramme that the ECB could an­nounce as early as next week.

OMT and QE are not the same beasts, but both in­volve buy­ing sov­er­eign debt. OMT is an as yet un­used pol­icy un­der which the ECB would buy the sov­er­eign bonds of a trou­bled mem­ber state go­ing through an adjustment pro­gramme. The main aim would be to pre­vent bond yields from ris­ing to un­af­ford­able lev­els, with the ECB ster­il­is­ing its pur­chases to con­trol liq­uid­ity.

Last year, the Ger­man Fed­eral Con­sti­tu­tional Court ruled that the pro­gramme went beyond the ECB’s man­date, on the grounds that eu­ro­zone rules pro­hibit the cen­tral bank from fund­ing in­di­vid­ual states.

In con­trast, QE would in­volve the un­ster­ilised pur­chase of gov­ern­ment bonds and would not be linked to re­forms in any given coun­try. Nev­er­the­less, the ECJ’s an­swers to two key ques­tions could im­pose ma­jor re­stric­tions on the de­sign of a po­ten­tial ECB as­set pur­chase pro­gramme:

1) Does QE rep­re­sent fis­cal as well as mon­e­tary pol­icy? For ex­am­ple, if the ECB bought Ital­ian bonds and Rome sub­se­quently de­faulted, the ECB could suf­fer a loss re­quir­ing re­cap­i­tal­i­sa­tion by its mem­bers, or in other words Euro­pean tax pay­ers. If pur­chases of gov­ern­ment bonds were un­lim­ited, the cost to tax­pay­ers could be in­cal­cu­la­ble. At the same time, by driv­ing sov­er­eign bond yields lower, the ECB could over­ride the mar­ket forces that pres­sure gov­ern­ments into im­ple­ment­ing re­forms, ex­ac­er­bat­ing the risk of moral haz­ard.

2) Would ECB bond pur­chases amount to debt mu­tu­al­i­sa­tion? That would con­sti­tute a step to­wards fis­cal union that Ger­many ve­he­mently op­poses. More­over, un­der Ar­ti­cle 125 of the Lis­bon Treaty it is il­le­gal for one mem­ber to as­sume the debts of another.

It is likely that the ECJ will rule largely in favour of the ECB, ac­cept­ing the cen­tral bank’s ar­gu­ment that the OMT, even though un­used, was a valid tool en­abling the ECB to achieve its mon­e­tary pol­icy goals. The an­nounce­ment of OMT in 2012 clearly sta­bilised mar­kets and low­ered bond yields help­ing the ECB achieve another one of its man­dates, the sur­vival of the euro. The ECB couches its ad­vo­cacy of QE in sim­i­lar terms, por­tray­ing it as a mon­e­tary pol­icy tool de­signed to lift growth and in­fla­tion ex­pec­ta­tions and counter the risk of stag­na­tion or even a self-ful­fill­ing de­fla­tion­ary spi­ral as busi­nesses and con­sumers cut in­vest­ment and spend­ing in re­sponse to a wors­en­ing eco­nomic out­look.

An out­right re­jec­tion of OMT from the ECJ would se­verely dam­age hopes for QE, un­der­min­ing the ECB’s cred­i­bil­ity and send­ing eu­ro­zone risk as­sets into a tail­spin. Yet the ECJ’s un­qual­i­fied back­ing is far from guar­an­teed. Given that the Ger­man Fed­eral Con­sti­tu­tional Court has the power to stop Bun­des­bank par­tic­i­pa­tion in a pro­gramme that it thinks breaks EU law, the ECJ can­not af­ford to ig­nore its con­cerns com­pletely. That makes im­ple­ment­ing a vi­able scheme of as­set pur­chases to flat­ten curves and force yields lower even trick­ier. Not only must the ECB de­sign a pro­gramme that op­er­ates across nearly 20 sov­er­eign yield curves, all with dif­fer­ent cur­va­tures and dif­fer­ent spreads to bunds, it must also ac­com­mo­date Ger­man con­cerns about risk shar­ing and moral haz­ard. It has three main points to con­sider: 1) Will the cen­tral bank buy bonds in pro­por­tion to coun­tries’ out­stand­ing debt or in pro­por­tion to their share­hold­ing in the ECB? Coun­tries with high debts, such as Italy, ben­e­fit more from the for­mer; those with lower debts from the lat­ter.

2) How will the ECB ad­dress the Ger­man risk shar­ing con­cerns? One way would be to as­sign bond pur­chases to na­tional cen­tral banks, which would in­di­vid­u­ally bear the risk of de­fault. That way the Bun­des­bank would not be ex­posed to any po­ten­tial de­fault by, for ex­am­ple, Italy or Greece. The draw­back is that this op­tion would im­plic­itly ac­cept the pos­si­bil­ity of de­fault, and would run counter to the prin­ci­ple of greater eu­ro­zone in­te­gra­tion. Al­ter­na­tively, the ECB could buy bonds of cer­tain credit rat­ings, such as AAA or in­vest­ment grade only, to min­imise the risk to its bal­ance sheet. Buy­ing in­vest­ment grade only would ex­clude both Greece and Por­tu­gal (both of which have par­lia­men­tary elec­tions this year). Buy­ing AAA bonds only would re­quire sig­nif­i­cantly larger pur­chases to force down the yields in pe­riph­eral mar­kets.

3) Where on the curve will the ECB buy? It would make lit­tle sense to buy bonds with neg­a­tive yields, so pur­chases of Ger­man debt would most likely take place in the mid­dle to long end of the curve, while pur­chases across the curve would be more likely in pe­riph­eral mar­kets.

The dif­fi­culty of de­sign­ing a pro­gramme that solves all th­ese prob­lems leaves plenty of room for the ECB to un­der­whelm, es­pe­cially since the Ger­man mem­bers of the cen­tral bank’s gov­ern­ing coun­cil re­main firmly op­posed to QE, not just for the rea­sons out­lined above but be­cause they don’t be­lieve it can work.

As a re­sult, the ECB’s gov­ern­ing coun­cil may face an un­palat­able choice be­tween over­rul­ing its Bun­des­bank mem­bers or send­ing mar­kets into a vi­cious tail­spin should QE ex­clude Ital­ian and Span­ish bonds, or fall short of the ex­pected EUR 500 bln.

To po­si­tion them­selves for ei­ther pos­si­bil­ity, in­vestors should con­sider go­ing long Ger­man, Span­ish and Ital­ian 30year bonds, in the pro­por­tion 50% bunds and 25% each in Span­ish bonos and Ital­ian BTPs, in a bal­anced ap­proach sim­i­lar to that long ad­vo­cated by some an­a­lysts. If QE un­der­whelms, Ger­man bunds would ben­e­fit from a risk-off move, while if the ECB de­liv­ers, Span­ish and Ital­ian bonds will rally.

A mix of the three should suc­cess­fully re­duce the port­fo­lio risk go­ing into this month’s key Euro­pean de­ci­sions.

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