To­wards Eu­ro­zone re­fla­tion

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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

ag­gres­sive and

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.

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