Towards Eurozone reflation
Last Thursday, European Central Bank president Mario Draghi unveiled plans to buy at least EUR 1.1 trln of public, private and supranational debt securities over the next 20 months. And if necessary, the ECB could extend and accelerate this quantitative easing programme, expanding its balance sheet by as much as EUR 3 trln, or 30% of the eurozone’s gross domestic product, to hit its inflation target.
In 2012, when the euro was perceived to be on the brink of collapse, it took months for the ECB to tackle the crisis with its Outright Monetary Transactions bazooka. Two years later, it again took months for the ECB to address the risk of deflation with another credible bazooka. This was loaded and fired last week with the announcement of plans to purchase EUR 60 bln of securities each month from March 2015 to September 2016 - more than even the greatest optimists expected. Of that amount, at least 75% will be government bonds of 2-year to 30-year maturities, purchased in proportion to each country’s share in the ECB’s capital. Moreover, the ECB retains the option to expand its programme substantially, buying up to 33% of each issuer’s outstanding debt. That would put sovereign QE at a theoretical maximum of between EUR 2 trln and 2.5 trln, or 20% to 25% of GDP, depending on how the different rules combine. Finally, the ECB has enhanced its quarterly Targeted Long Term Refinancing Operations, scrapping the 10bp margin over its short-term refinancing rate. Combining these operations - sovereign QE, supranational QE, private QE and the TLTROs - the ECB balance sheet could expand by some EUR 3trn. A big bazooka indeed.
By decentralising the ‘risks’ of QE at the level of Europe’s national central banks, the ECB has managed to design a programme that does not endanger its authority, since local central banks are bound by law to apply the ECB’s rulings. In addition, as Draghi noted, the OMT programme will still apply if a country is at risk of default, which implies that the risks will ultimately be mutualised. Thus it is clear that Europe has taken another major step towards ‘federalism’.
Many economists remain skeptical about QE’s ability to boost nominal GDP growth. They argue that eurozone bond yields are already very low, and that the window of opportunity might have closed, as deflationary forces may already be too deeply entrenched for QE to have much effect. But for the next couple of years at least, reflationary forces are likely to prevail, as the ECB’s QE will take place during a favourable period of US dollar strength and sharply lower oil prices, which act as the equivalent of a fiscal boost from a tax cut.
For these reasons we think there will be no more downward revisions to eurozone real GDP growth. The latest ECB lending survey has confirmed the continued improvement in lending conditions, and the Bundesbank is now pointing to upside risks for growth in Germany this year. Eurozone consumer confidence is also up in January, retracing most of last summer’s fall.
Now it makes sense to turn more
to overweight European equities, while staying long the very long end of peripheral bond yield curves. Our hedging strategy remains unchanged: long positions in the 30-year US bond remain best placed to protect European portfolios from episodes of volatility.