Draghi, get to the chopper

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In the 1987 hit movie Predator, Major “Dutch” Schaefer, played by muscle man Arnold Schwarzenegger, orders his team-member to “get to the chopper” to escape the jungle creature. Markets now expect European Central Bank President Mario Draghi on 22 January to flex his monetary muscles and save the day by jumping into his metaphorical helicopter and throwing huge amounts of cash at the Eurozone’s problems.

What markets expect

Of course this is a crude metaphor because quantitative easing (QE) is not akin to printing money and simply distributing it to every man and woman in the hope that bond yields fall and growth picks up[1]. Nevertheless, markets are expecting, almost willing, the ECB to deliver a bold bond-buying program at its policy meeting on 22 January (the announcement is due at 12.45 UK time and President Draghi’s press conference is set to follow at 13.30).

The Swiss National Bank’s recent decision to abandon the EUR/CHF 1.20 floor has led to speculation that the SNB knows something we don’t about the scale of the ECB’s planned QE and fuelled expectations that the ECB will have its own shock-and-awe moment.

What the ECB will announce – Devil in the detail

While most participants agree on what the broad framework may look like, the specific modalities of the ECB’s QE are far more uncertain, the product of complex and protracted negotiations amongst the main actors. In particular, Germany is intent on shaping a bond-buying program that minimise the costs it bears and the risk of skewed incentive structures.

As often the case, the devil will be in the detail, including:

  • Size: Draghi said he expected the central bank’s balance sheet to return to March 2012 levels (around EUR 3trn[2]), implying a € 800bn (5% of GDP) bond buying program; note this was an expectation not a firm commitment; There’s an argument that size doesn’t matter because the package will be ultimately be as big as it needs to be to drive inflation back up to 2%. That may be true but we should not underestimate the signalling power of QE. The announcement of a small package could dent its effectiveness and lead either to its premature abandonment or the need for an even greater package than markets originally hoped for.
  • Type of debt purchased: This size would likely to have to include Eurozone member states’ sovereign bonds, not just private debt;
  • Who will buy what: Germany is pressuring the ECB to ask the 19 individual central banks to buy their own country’s bonds and be responsible for any losses, with weaker sovereigns asked to put aside greater provisions. This would fly in the face of the risk-sharing principle, as espoused for example in the SMP. The ECB may be restricted to buying only bonds of a certain credit rating or maturity (Germany’s preference is reportedly for shorter-dated bonds) or bonds issued by the European Investment Bank.
  • Conditionality: German officials have stated their preference that any form of QE should impose rigorous conditionalitys on the countries whose bonds are being purchased, including the adherence to fiscal reform targets.
  • Program tenure: The program is likely to be open ended, as was the Outright Monetary Transactions (OMT), or at least until inflation is closer to the ECB’s 2% target.

How it will work in theory

Market participants and policy-makers will have a slightly different take on what the ECB QE should seek to achieve, but I think its objectives can be summed up as follows:

1. Near-term, put a lid on Eurozone systemic risk. This is a less pressing or ambitious goal than in the 2012 when the OMT was announced and despite never being enacted seemingly contributed to curbing high government bond yields and acute systemic risk (i.e. countries exiting the Eurozone). While contagion is always a risk, systemic weakness today plagues mainly Greece with sovereign yields near record lows in Ireland, Italy, Portugal and Spain (see Figure 1).

olivier desbarres

Figure 1: 10-year government bond yields are near record lows…except in Greece

2. Medium-term, generate jobs, economic growth and inflation. This is arguably a far bigger and increasingly pressing goal. Eurozone unemployment rate is flat-lining at 11.5%, inflation was negative in December and inflation expectations have fallen with 5y-5y inflation swap prices now sub-1.5%. While the channels through which QE is designed operate are country and time specific, they tend to include increased lending, confidence (via asset prices), borrowing, spending, investment and export competitiveness (see Figure 2).

Figure 2:  The channels through which QE is supposed to work its magic

Figure 2: The channels through which QE is supposed to work its magic

How it will work in practice

As I argue in European Central Bank QE: a little late to the party, that’s a tall ask for what is in most instances a measure of last resort and one which is being introduced very late in the game. The Fed stopped its purchases of mortgage-backed securities and Treasury notes in October 2014 while the BoE’s last QE size increase was in July 2012.

The million dollar question is whether the lower cost of money and higher quantity of money will translate into greater confidence, borrowing, spending and investment. As the experience of Japan showed, the ability to borrow is not the same as the willingness to borrow nor should it be a substitute for reform. Furthermore, only a handful of countries, including Germany, are in a position to fully capitalise on a more competitive euro. Ultimately, it will take months (an eternity in market-terms) rather than days or weeks to properly ascertain the efficacy of ECB QE, in my view

Weaker euro is no miracle bullet

The voids between what the markets expect, what the ECB announces and whether it works are tricky to measure and muddy the euro’s path.

However, I think that if the ECB delivers a big and bold plain vanilla program with risk-sharing – the latter looking increasingly unlikely in my view – the euro may temporarily rebound – ironically not what the Eurozone’s exporter’s need. The pressure medium-term may still be on EUR/USD downside as the question is still when, not whether, the Fed will hike in 2015.

If the ECB underwhelms with a hard to digest middle-of-the road or watered-down program clipped and curtailed by German demands the euro may resume its slide on market expectations that the ECB will have no choice but to announce another program to paper over the cracks in cyclical and structural GDP growth.

In any case, the FX market will likely temper its enthusiasm, or lack of, given that Greece is holding elections only three days later on 25th January. Opinions polls still have Syriza leading some form of coalition government but it could be weeks before the new government articulates a clear stance regarding Greece’s austerity program and existing bailout-package which still has EUR 15bn to disburse.

It is not unfeasible that once again the Eurozone has to choose between a significant restructuring and/or write down of Greek debt or letting Greece leave the monetary union – not be the backdrop that Eurozone leaders hoped for as they grapple with relaunching growth.

 

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He is a former G10 and emerging markets economist, rates and currency strategist with over 15 years’ experience with two of the world’s largest investment banks.


[1] QE amounts to a change in the composition of the private sector’s balance sheets, swapping bonds (low liquidity) for reserves (high liquidity) and a corresponding increase in the central bank’s balance sheet (incidentally the physical creation of banknotes and coins in the US is the preserve of the Treasury, not the Fed). The twin objective is to lower the cost of (long-term) money and the quantity of money banks can lend, with the ultimate goal of boosting lending, confidence (via asset prices), borrowing, spending/investment and ultimately growth and/or inflation. But there is “creation” of money only if increased bank reserves translate into increased lending.

[2] See http://www.ecb.europa.eu/press/pr/wfs/2012/html/index.en.html

Sources

Fig 1 – www.investing.com

Fig 2 – www.olivierdesbarres.co.uk

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