Worth considering the merits of doing QE at this time, says AXA’s Iggo
Banks are still not in a position to lend and there is no guarantee that announcing QE now would help push inflation up in the near term, says Chris Iggo CIO Fixed Income at AXA IM.
Draghi may want to keep his powder dry for a time when there might be a greater return on pulling the trigger on QE. At any rate, central bankers must be quite reassured that macro and market volatility is at a lull at present.
This could change with stronger US data and upward pressure on market yields. I doubt total returns will be as strong as they have been in Q1.
The clamour for European QE – The ECB kept the market guessing this week with its announcement of unchanged policy at the same time as discussing the possible use of further conventional and then unconventional monetary policies if disinflation is prolonged. There is a certain clamour in the markets for the ECB to do something unconventional and this has been encouraged recently by comments from Bundesbank President Wiedmann and by Draghi himself refusing to rule out QE.
But let’s think about it, what would the benefit of QE be? In the post-financial crisis there have been (will be) four phases of monetary policy. The first was the aggressive cuts in interest rates that followed the collapse of Lehman Brothers in 2008. This lead to a lower and steeper yield curve. The second was – at least in the US and UK – QE which led to lower long term yields and a flattening of the curve brought about by aggressive purchases of government bonds by central banks.
The third has been the attempt to keep intermediate interest rates low and monetary policy expectations well anchored through forward guidance. The last phase will be normalisation which would entail increases in short term rates and a bearish flattening of the yield curve.
Of course, the path of the ECB’s monetary policy has been somewhat different to that of the US and UK because it had a sovereign default problem to try and solve, thus its LTRO policy was aimed at providing enough liquidity to the Euro Area banking system to allow banks to buy government bonds and thus facilitate a narrowing of credit spreads between sovereign issuers in the same currency bloc.
It was a different form of QE involving an extension of the ECB’s balance sheet (although on a temporary basis) and targeted at reducing government bond yields. It worked. Bond yields are lower and the German curve is much lower than US Treasuries and gilts, while sovereign peripheral spreads today are at their lowest levels since 2010. The ECB has even adopted a form of QE, implying that it will keep interest rates on hold for a very long time.
Why not? – So why the clamour for QE today if much of the benefit of QE has already been accomplished without the ECB doing the same thing as the Federal Reserve (Fed) and the Bank of England (BoE) and the Bank of Japan (BoJ)? One answer would possibly be based on the argument that it is the stock of liquidity provided by QE that is important rather than the flow. The Fed, BoE and BoJ have added permanent liquidity through the expansion of their balance sheet while for the ECB, through the LTRO, it has been temporary and is already in decline. A second argument is that the European Economy still needs help because growth is weak and inflation is very low.
A third is that the Euro is too strong and is threatening the recovery through making Euro exports less competitive and that QE might bring the exchange rate lower. A fourth is the sentiment argument. The announcement of QE would be taken well by investors, it might bring yields and spreads even lower and the exchange rate down, and the link between QE and a stronger economic recovery would be established for the Euro Area in the same way as it has been established in the US, UK and Japan.
Why not, not – So why has the Governing Council resisted? An obvious and maybe understated reason is the political constraints and the possible legal challenges to a policy that could be construed as monetary financing. A second, is that the monetary transmission mechanism remains broken. It could be argued that QE was able to transmit lower interest rates to the real economy once the banks had been recapitalised and once other government initiatives in the US and UK had been established.
After all, it was the Funding for Lending and Help to Buy schemes in the UK that got credit flowing, while the US banks are well ahead of their European counterparts in terms of balance sheet strengthening.
Europe is not in a position for this yet and won’t be until the Asset Quality Review/Stress Tests are out of the way. So Mr Draghi may be taking the view that rates and spreads are already very low and that the ECB could face considerable political opposition from starting a course of action that would not boost credit growth yet anyway. Meanwhile, targeting the exchange rate is pretty imprecise and also runs the risk of upsetting G7 partners.
If not now, could it be later? – I have seen discussions about the risk of Japanification in Europe and accusations of ECB complacency that could exacerbate the current disinflation. Next week we get preliminary Consumer Price Index data for March which is expected to show a further easing of annual inflation rates. Of course, at the heart of the Euro Area is Germany which has a culture of low inflation and a determination to keep inflation low. The March inflation rate is expected to be 1.0% in Germany. Because of the need to restore competitiveness elsewhere, inflation needs to be low, hence the negative annual inflation rate in Spain.
To raise Euro Area inflation we need to see higher inflation in Germany – so things like more generous wage settlements and a weaker exchange rate need to be seen. Can QE, which is a fairly blunt tool, deliver an inflation rate closer to the ECB’s target? While economic activity has revived in the US and UK, inflation is actually still very low in those economies – 1.1% in the US in February, 1.7% in the UK.
Yes, aggressive QE has stopped in both those economies but to make anything other than a coincident link between QE of a couple of years ago and higher inflation of a couple of years ago would be disingenuous to say the least. Doing QE today may not deliver much but in the future, when maybe there is more upward pressure on bond yields as the Fed gets closer to normalisation, QE may achieve more, particularly if the banks are in a stronger position and the dollar is rising anyway.
Inflation, the top and bottom – The bond markets have not done much. We are in a period of reduced macro and market volatility. It’s difficult to generate strong returns in such a market. In our global bond universe the best performing asset class in March was sterling inflation linked with a total return of 1.5% as real yields fell and break-evens rose. The worst performing asset class was US inflation with a total return of -0.5%.
That spread between best and worst is at the low end of recent monthly performance in the bond market and is much less than the stressed returns we saw in May and June last year. Interestingly, European inflation delivered a first quarter return of 2.7% which is almost exactly the same as Bunds so an investor was not punished for holding inflation linked assets in Europe relative to conventional government bonds even though spot inflation has moved lower.
I would warn against complacency on bond performance overall though. We could easily be entering a period of stronger US economic data prints and rising interest rate expectations – even if it only turns out to be temporary. High yield and equity returns did slow in the first quarter compared to the end of last year, but steady growth and low inflation seems to be a positive macro backdrop for these assets.
The recurring concern is valuation and the lack of much of a cushion against wider risk spreads. I personally think the returns seen so far in the bond market can’t be sustained for the whole year and I sort of like the bar-bell position of very short and very long duration where yield curves are steep. The long-end of the sterling credit market delivers a yield to maturity of 4.7% at present, which looks attractive relative to 10-year gilts at 2.76% because I don’t see a reason why the long end of the curve would steepen significantly further today and 10-year yields are vulnerable to a change in BoE expectations.
Springtime – We are on summer time now and the evenings are lighter- great that it’s not dark on both arrival and departure anymore. April is a special time in the UK – this weekend sees the Grand National being run in Liverpool and the annual Boat Race taking place on the Thames. I will have interest in both events – it’s a tradition to have a bet on the greatest steeple chase in the world and I will be rooting for Cambridge on Sunday as its crew uses my son’s school’s boat house, to which I am a regular visitor these days.
In the next week there are the FA Cup semi-finals, the London marathon and the second-legs of the European Champions League quarter-finals. Paris St-Germain look a cert to go through, as do Real Madrid, but the other ties are finely balanced including Manchester United’s with Bayern Munich. Any early away goal in the Allianz Arena on Wednesday will boost United’s chances but it will be tough against the champions in their home ground in Bavaria. I will be discussing bond markets and economics with clients in Guernsey at the time, trying my best not to be distracted by what I hope will be an early goal alert on my phone.