What’s driving bond yields up?

The ECB has been delighted with the response to its asset purchase programme, and indeed the initial reaction from  all asset classes, from bonds through to equities and FX, was both significant and supportive of the Bank’s attempts to stimulate economic activity. The ECB first announced its intention to buy  private sector debt last September, with the euro trading at $1.29, and the single currency subsequently declined to under $1.05  following the January decision to extend QE to government bonds and the  commencement of purchases  in early March. European stock markets rose sharply in the months after the January decision and bond yields continued the trend decline begun last autumn; Irish 10-year yields fell to a low of 0.65% and the German equivalent traded at 7bp, with negative yields prevalent in that market up to an including the 5-year maturity.

The picture looks rather different today.  Government bond yields have risen sharply amid very volatile trading, with 10-year yields in most markets back up to levels seen last October. German  4 and 5-year yields  are now positive again  and the major European equity markets have fallen by around 10% from the highs, with the euro also gaining ground, trading above $1.12.  QE is still  proceeding according to plan and the ECB’s balance sheet is expanding as intended ( €2.42 trillion at end- May from €2.15 trillion at end-2014)   so the fall in asset prices has prompted some  puzzlement, with  a number of  explanations vying for supremacy.

One approach emphasizes  bond  fundamentals, starting with real interest rates and the outlook for economic growth. The  macro data in the euro zone has tended to surprise to the upside in recent months and there was some modest upward revisions to near-term growth forecasts  but the consensus projections for the next few years have not really changed, with most still expecting a sub 2% expansion in the EA.  Similarly the outlook for the global economy has not materially changed (if anything,  the growth forecast for this year have moved lower) so it does not seem likely that real interest rates have suddenly moved higher.

Nominal bond yields are also determined by  inflation expectations (plus a risk premium) and again  forecasts  for EA inflation have not materially changed of late, including those from the ECB,  which foresees a gradual return to annual inflations rates approaching 2%.  Actual inflation has turned positive, it has to be said, so perhaps the deflation scare has abated, although it was always difficult to know if that was really a major concern for investors. Expectations on one of the ECB’s most closely watched measures (the 5 year five year forward inflation swap) are  around 1.75%, which is well up from the sub 1.50% lows but not signaling any inflation scare.

Some peripheral bond markets have fared worse than others during the sell-off  (Portugal for example) but a generalized contagion from Greece is not evident, at least not yet, given that 10-yr bund yields  have also risen sharply, by over 80bp in the past 6 weeks.

Other explanations emphasis market conditions. Issuance in some markets has been higher than expected, for example, including corporate debt. Lack of liquidity may also be  a factor, as a consequence of banks having to hold more  regulatory capital. This , alongside the Volckler rule, has persuaded many market-makers to hold less inventory, with the result that a given degree of selling will have a much greater impact on the market price than it would have done a few years ago. Certainly the scale of intra-day volatility (up to 16bp in 10-year bund yields) is far higher than normal, supporting the idea of thinner markets.

Another  explanation highlights the different types of bond buyers, each with varying risk  tolerances and trading objectives. Banks are required to hold more liquid assets under new Basel regulations, and  so  have bought shorter-dated bonds even at negative yields , particularly as for some the alternative is a deposit with the ECB at an interest rate of -0.2% (overnight ECB deposits are still high, at  €100bn). Credit conditions are improving in the EA, however, with a modest pick up in lending to the private sector, so  some banks are finally using the ample liquidity available to support credit creation to firms and households.

Hedge funds and other traders are looking for a short term return and here the predominant  trading style may be a factor- momentum trading is the order of the day for many, which explains why a trend already well established can persist long after some feel it has lost touch with fundamentals.  The problem arises when the trend  changes and many are then heading for the door, which is suddenly crowded. The lack of liquidity  is exacerbating the downdraft.

‘Real money’ investors, such as pension and insurance funds, are also important, but usually ‘buy-to-hold’ and generally players at longer maturities. They are therefore  less likely  to get caught up in a specific trading style and may well step in following a sharp  sell-off, so putting a floor in the market.

All these explanations, fundamental and market related, are not mutually exclusive, of course, and I suspect the sell-off owes most to the  recent inflation data and the acceleration in monetary growth, with the exit from a crowded trade also playing a big role. One should also keep the correction in perspective- bond yields (government and corporate ) are still extremely low by normal standards and hence  nominal financial conditions  remain unusually  loose, even if a little tighter of late.  In the shorter term it may well be  the actions of  the Fed, rather than the ECB, that helps determine the next big move in EA yields.

ECB to buy Government debt but limited risk sharing

The ECB today decided to buy sovereign debt, a decision  which, although widely anticipated, had the immediate effect of weakening the euro further on the FX markets and  giving a further fillip to government bonds, which were already at record yield lows in many cases. Equities too rallied although it remains to be seen  when the dust settles how much of the ECB policy change  was already priced in to markets.

Mario Draghi gave two reasons for the move. First, inflation has been weaker than expected and inflation expectations have fallen further, which could in turn have a negative impact on wage and price developments particularly given the level of spare capacity in the euro zone.Second, the existing monetary policy measures in place have not had much of an impact and in that context it was announced that the interest rate on the long term loans available to banks (the TLTRO) will be reduced from 0.15% to 0.05% , an implicit admission that the take-up has been disappointing.

The ECB is also currently buying private sector debt (covered bonds and asset backed securities) in the secondary market  but again the impact has been limited, with only €35bn purchased to date. Consequently the ECB decided to significantly expand the programme to include public sector debt (Government and European Institutions), although some in the council were still of a mind to wait and see how inflation develops in the coming months. The expanded QE programme will now amount to €60bn per month, starting in March and continuing until September 2016,with the prospect of extending it further until there is a ‘a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term’. The minimum purchased will therefore be €1,080bn and the final figure may be well above that .

One area of market debate ahead of the decision was the issue of risk sharing-  the ECB had shared the risk of the Securities Market Programme ( a previous and limited excursion into the sovereign debt market)  but there was some opposition to this in terms of QE, notably from Germany. In the event 12% of the purchases will be European institutional debt and all the risk of that will be shared, with the ECB also purchasing another 8% of debt on its own books. Consequently 80% of bonds purchased will be at the risk  of national central banks, implying over 90% of bonds excluding the European institutional debt.

Another question was which sovereign  bonds to buy and the ECB decided to allocate purchases by using the capital key ( each national bank’s contribution to the ECB’s capital). Euro countries provide only 70%  of the later so one assumes that the share will be adjusted pro rata for the euro members.  This would give Germany a figure of 25.6%, France 20.2%, Italy 17.5% and Ireland 1.7%.Clearly, then, purchases of German, French and Italian debt will dominate. If one assumes that €50bn of the monthly purchase is sovereign debt (the rest private sector and European Institutions) the figure for Ireland would be €0.8bn against over €12bn for Germany. The respective debt markets are very different in size though so it is more meaningful to estimate how much of the market would be owned by central banks after 18 months and that gives some interesting results; the central bank would hold 19% of Portugal’s debt, over 14% in Germany, some 13% in Ireland but less than 9% in Italy.  Indeed, in some of the smaller EA  countries with little debt the scheme would imply less than half the debt left in private hands,  and so the ECB announced certain limits, including 30% of the issuer as a maximum.

What  impact will it have on the real economy? When asked, Draghi put forward three  effects. The scheme  is a very significant move for the ECB and hence may boost inflation expectations. Second it will lower funding costs further and hence  may stimulate credit growth and spending. Third it will strengthen the ECB’s forward guidance on interest rates. He did not add it has already resulted in a currency depreciation. Will it work? QE in the UK and the US certainly seemed to boost equity markets and growth did pick up, although core inflation in both economies is still below respective central bank inflation targets. Draghi himself does not seem too hopeful – he responded  to a question about the risks of hyper-inflation when central banks print money by pointing out that  that inflation has not taken off elsewhere in the wake of QE. This begs the obvious question as to its usefulness as a tool in generating inflation in the EA, such is the weakness of domestic demand, but the ECB is clearly desperate to try everything in an envoronmnet when an alternative, expanding fiscal  policy, is deemed verboten.

ECB -where to from here?

The ECB’s mandate is to deliver price stability, which the Bank itself initially defined as an annual inflation rate below 2%. Clearly there was no thought given to the risks of deflation with such an asymmetric target and the definition was subsequently tweaked to the current ‘below but close to 2%’. Euro area inflation fell below 2% in early 2013 and below 1% a year ago, with the latest ECB staff forecast projecting very low inflation for at least another two years. Moreover , the forecast was predicated on oil prices averaging $86 a barrel next year , which now looks high given that Brent is currently trading under $70.

There are ‘long and variable’ time lags with monetary policy, so one could argue that the current low inflation rate (the flash figure for November was 0.3%) reflects policy decisions made some time ago-remember the ECB actually tightened policy in 2011. Against that backdrop the recent press conference by ECB President Draghi was remarkable in many ways, not least because he had promised ‘immediate action’ on inflation in a speech in the latter part of November.

In the event the only change of note was in the language surrounding an expansion of the ECB’s balance sheet, which had been  ‘expected‘ to reach the level seen in early 2012 but now measures are ‘intended’ to achieve that level. That would entail an increase of about €1,000bn and clearly there is no agreement within the ECB to promote that as a target. Indeed, Draghi stated that there was not unanimity among the 6-member Executive Board on the announced change in wording, limited as it was.

Draghi had previously played down disagreements within the Governing Council but here seemed willing to place them out in the open, emphasising at one point that previous decisions had been taken  by majority. The obvious divisions  on further policy action made for an uncomfortable conference, however, with Draghi having to again indicate the need for more time to assess the situation despite more forecast downgrades and the blatant contradiction between that  approach and his earlier promise of ‘immediate action’

The upshot is that the Governing Council will reassess the situation ‘early next year’  including the size of the balance sheet. That will be affected by the existing bond buying programme (albeit the figure to date is just €22.5bn) and the outcome of the second targeted long term loan operation (the TLTRO). The latter saw a low uptake for the first tranche (€82bn) and there is a wide range of expectations with regard to the one upcoming, while there will be some offsetting downward pressure on the balance sheet via repayment of previous long term lending to the banks.

The euro rallied during the conference, which was attributed to disappointment about a  QE announcement, although that remains  the market’s general expectation. For others, including this writer, it remains less than a certainty that the ECB will eventually buy sovereign debt, and if it does it is not at all clear how much of an impact it will have on economic activity and inflation, leaving aside the impact it has already had on asset prices. A lot of uncertainty then, and one wonders if the next few months will see further resignations from the ECB Council given the fundamental disagreements on the next steps for monetary policy.

Are current euro sovereign yields irrational?

The Irish Government issued a 15-year bond recently at a yield of 2.49% and the 10-year benchmark is trading at under 1.6%, a far cry from the double digit levels seen in the latter just a few years ago. Sovereign yields across the euro area have plunged of course ; 10-year yields in Italy are down at 2.3%, Spain is trading at 2.1% while Portugal is just over 3%.The perceived risk of default  over the next five years has clearly changed dramatically and judging by Credit Default Spreads is now around 10% for Italy, 17% for Portugal and less than 5% for Ireland.

German yields are lower still and bund yields can be considered the nearest thing to a risk-free rate in the euro area. Consequently, a 10-year bund rate of just 0.8% implies that the market expects short term  euro interest rates to stay low for a long time and then to rise only slowly; the implied 5-year forward yield in five years time is under 1.5%.Interest rates are also extremely low in other currencies but higher than bunds, with the US 10-year yield at 2.34% and the UK  trading at 2.1%. The 5-year forward rates also tell a  very different story- the US implied yield is just over 3% , with the UK at 2.8%.So the bund curve indicates  that investors expect inflation to stay low for a long time and not to threaten the ECB’s 2% target. This , in turn, indicates an expectation that growth will remain weak in Germany, with the prospect of  secular stagnation clearly seen by many investors  as more than just an academic debating point.

That scenario  may or may not materialize but it would appear to be a plausible rationale for the current level of bund yields. The problem is , though, that such a scenario would be very negative for other euro zone economies, particularly those with extremely high debt burdens and needing an internal devaluation to become more competitive within the zone. A prolonged period of very low nominal GDP growth, possibly with price deflation, would severely damage fiscal capacity and via the denominator put further pressure on already stretched debt ratios; Italy’s ratio in q2 of this year  was 134% , for example, with Portugal at 129%.Indeed, Italy’s GDP is already falling steadily and in real terms is back to the level recorded in early 2000.

Buyers of peripheral euro sovereign bonds can point to Draghi’s ‘whatever it takes’ mantra and  it would seem that the market views full-blown QE (i.e. buying sovereign debt)  by the ECB as inevitable and that somehow this will save the day. The Governing Council is clearly split on the issue, however, and some opposed the current plan to buy Asset Backed securities which explains why Draghi is at pains to add the qualification ‘within our mandate’ to his statement that there is unanimous support for additional non-standard policy measures.- clearly some members feel that the ECB could be acting ultra vires. So QE is not inevitable but if it did emerge (through a majority vote perhaps) it is still problematical relative to experience elsewhere. The banking system in Europe  is the main source of credit, unlike the US where the disintermediation of banks is the norm, so QE may not have much impact. Moreover Central banks in the US, the UK and Japan have bought their own sovereign bonds but the ECB has no sovereign bonds to buy- it would have to choose among the sovereign bonds of the 19 member states. How would it proceed if it chose a €1,000bn target- would it buy in proportion to the country weights within the euro area, or target higher yields? The former would imply the purchase of large amounts of  bunds and say only €12bn of Irish bonds. In addition the ECB would be buying at extremely low yields ( elevated prices) so adding a high degree of market risk to the credit risk inherent in QE.

More fundamentally, transferring ownership of some sovereign debt from one group of investors to another (in this case the ECB) does nothing to change the debt burden unless of course one believes that the ECB will effectively tear up the bonds or hold to maturity and then pass the proceeds back to the respective governments. One doubts if that would be acceptable to the Germanic school within the Governing Council, at least on any scale that would make much difference to high debt countries, but such concerns do not seem to weigh much on investors at the moment.

Early repayment of Ireland’s IMF debt

The Irish Government is exploring he possibility of  early repayment of the monies borrowed from the IMF and below we examine the issue.

How much does Ireland owe the IMF?

Ireland  arranged to borrow €22.5bn from the IMF as part of the bailout deal agreed with the Troika, although the fund actually lends in Special Drawing Rights (SDR’s) , the IMF’s unit of account, which is constructed as a basket of four currencies (the US dollar,  euro, Yen and Sterling) with the dollar having the largest weight followed by the single currency. Ireland drew down SDR19.47bn from early 2011 through to late 2013 and the loans have maturities ranging from 4.5 years to 10 years, with an average maturity of 7.3 years. The SDR ‘s value against the euro changes daily and at the time of writing buys €1.16 so Ireland currently owes 22,6bn in euro terms, although the loan has to be repaid in SDR’s. In that sense Ireland can be said to have borrowed from the IMF in four currencies.

What is the interest rate on the loans?

Ireland has borrowed from the IMF under the Extended Fund Facility and the rate charged is floating, depending on the 3-month SDR rate ( itself a weighted basket of rates in the four constituent currencies) and a surcharge. The SDR rate is currently only 0.05% (the euro and yen rates are actually negative) so the premium is much more significant. That depends on how much one borrows relative to ones contribution to the fund , or quota, which is determined by GDP, population and other economic criteria. Ireland’s quota is SDR1.258bn and a country can borrow up to 3 times that (or SDR3.77bn in this case ) at a 1% surcharge. Anything beyond that carries a 3% surcharge , rising to 4% if the loan term extends beyond three years

So how much is Ireland paying?

If we assume the loan term will average 7.5 years Ireland would pay 1.05% per annum on the first SDR3.77bn and on the remaining SDR15.7bn 3.05% over the first three years and 4.05% on the final 4.5 years. This gives an average blended rate of 3.15%. In fact the loan  also carried a one-off 0.5% charge so averaging that out over the term  and adding it to the cost gives an annual rate of 3.21%. This is an SDR rate of course and Ireland raises taxes in euros, so the NTMA will use the swap market to convert euros in to the appropriate basket of currencies. Consequently the NTMA quotes an average euro rate for the loan based on a 7.5 year maturity swap, and that was put at just under 5% in March of this year, implying an annual interest payment in euros of over €1bn on the IMF loan. Ireland’s total interest bill on all outstanding debt  this year is just over €8bn.

How much is Ireland paying in the market?

Bond yields have collapsed across the euro zone on the expectation that short term rates will stay low for a very long time and, probably, in anticipation of bond purchases by the ECB. Irish yields have fallen precipitously too, with a government bond maturing in 10 years currently trading at 1.85%, with shorter maturities at much lower  yield levels. It would therefore appears that Ireland could borrow much more cheaply in the market than the current cost of the IMF loan  and it would make sense to borrow at a longer maturity given the low level of current yields..  The Minister for Finance has mentioned a figure of €18bn for repayment and yields would presumably rise if Ireland announced a much heavier issuance schedule  than currently planned ( only €10bn was slated for this year in total) but even at ,say 3.0% for a 20 year bond , the saving would be around €360mn a year , not counting any additional costs involved in breaking the swaps.

What’s the problem then?

There are two issues. One is that the other members of  the Troika need to sign off on early repayment, which brings in EU Governments  and in some cases parliaments. The second is the Promissory note deal, which involved the Irish government issuing  €25bn in long term bonds to the Irish Central bank . The ECB was never happy with the transaction, believing it to be ‘monetary financing’, and insisted that the Central bank sell the debt into the market over time. The schedule for the latter is light, with sales of €0.5bn a year out to 2018 before rising to €1bn a year, but Draghi now appears to be linking any ECB support for early IMF debt repayment with a more rapid sale by the Central bank.

Does the Prom deal matter that much?

The Irish Government  borrowed the €25bn from the Central Bank , which in turn borrowed from the ECB, and  the Government pays  a floating rate coupon of 6-month euribor ( currently 0.2%) plus 262 basis points on the bonds , implying an annual interest payment of €700mn. That  means a  large profit for the Central bank as its borrowing cost is now virtually zero, and most of this profit is transferred to  the exchequer. If ,say, the Central bank sold €5bn into private sector hands that circular flow of income would be broken, costing the exchequer, with interest payments now leaking out into the investors who bought the bonds from the Central bank while the latter would use the proceeds  of the sale to repay the ECB.

So the ECB’s call is key?

The ECB’s view is therefore very significant, as a much more rapid sale of bonds by the Central bank, in return for a nod on the IMF repayment,  would reduce the benefit of  the latter, by driving up Irish yields and  via a reduction in Central bank and therefore exchequer income. It is an irony though, and one that may well be pointed out by the Irish authorities, that Draghi is now  keen for the  ECB  to  eventually embark on full scale bond purchases across the euro area, which some might view as ‘monetary financing’ too, although no doubt Frankfurt will argue that the cases are different.

 

ECB Traversing outer limits of Policy

The ECB has travelled a long way in its thinking over the last few years, and following the latest round of measures is now at the outer limits of monetary policy, with little left in its armoury. Indeed, we may be moving closer to the point where European policy makers decide that putting all the pressure on monetary policy is a mistake, and that fiscal policy has to be more active when faced with a balance sheet recession and its aftermath.

Inflation in the euro area has been below the ECB’s 2% target for some time and Draghi has often emphasized the fragile nature of the limp economic recovery but the past month has seen a much more negative perspective emerge, as crystallised in the Bank’s economic projections; growth is expected to remain below 2% for the next three years and inflation is forecast to rise to just 1.4% in 2016 from 0.7% this year. Deflation is not seen as likely but such a prolonged period of low inflation is seen to carry  the risk that expectations of sub-2% inflation become embedded.

The ECB can only directly influence very short term interest rates ( the market determines longer rates) and Europe depends heavily on bank credit to finance private sector spending ( as opposed to bond financing) so any policy levers are largely dependent on the banking sector as the transmission mechanism, with the added complication that lending rates are much higher in some parts of the zone than others. The Bank tried to address that fragmentation by providing 3-year cash to the banks in late 2011 but over half of that has been repaid and many banks used it to fund the purchase of government debt, with the result that bank lending to non-financial corporations in the euro area is still contracting. That is due in part to the economic cycle ( demand for loans is low) but the ECB has copied the Bank of England’s  Funding for Lending scheme in seeking to influence the supply of credit  via the  provision of  funds aimed directly at the private sector. Under the targeted scheme (TLTRO)   euro area banks can access funds for up to four years, starting in September, at an initial rate of 0.25%, with an initial limit of some €400bn (7% of the outstanding loan stock ex mortgages) implying a figure in excess of €5.5bn for Irish banks given the €78bn outstanding in loans to non-financial firms (the figure could be higher if one includes personal debt ex mortgages). Draghi talked about monitoring the loans but at first site the penalty for not lending to the private sector is early repayment so it is not clear how much of a stick exists alongside the carrot. Further tranches can be drawn down depending on meeting benchmark targets on net credit growth.

The UK scheme did not have a huge impact and  it remains to be seen whether demand for loans will pick up particularly in depressed economies. Banks are also due to repay some €500bn of the remaining 3-year funding although the ECB has also decided to stop sterilizing the bonds purchased under the SMP, meaning it will no longer drain the equivalent amount of money from the system. The buying of private sector debt, via Asset Backed Securities, is also on the cards, although that will take some time to organise and the market there is small.

As noted the ECB can directly affect short rates and it cut the main refinancing rate by 10 basis points to 0.15%, which  will bring some modest gains to anyone on  a tracker loan and to banks borrowing from the ECB. Lower rates may also put some downward pressure on the currency on the FX markets and to aid in that the ECB cut its deposit rate to negative territory (-0.1%) and will supply as much short term liquidity as banks demand at a fixed rate out till the end of 2016. This puts some flesh on the pledge to keep rates at current levels for an extended period and seeks to influence longer term rates in the market. The euro had weakened in the weeks before the ECB meeting in early June as traders built up  short positions in anticipation of negative rates, but has not fallen further, at least as yet, highlighting that measures that are seen to reduce fragmentation in the euro area often serve to bolster the currency.

The forward guidance issued by the ECB also now excludes any reference to even lower rates and Draghi explicitly stated that we are at the end of the line in terms of rate reductions. Consequently, the  main weapon the ECB has left is full QE, but that is unlikely to have much affect on euro domestic demand given the importance of banking credit. Hence the TLTRO but if that does not work ( and it will take some time anyway for any impact to be felt) the conclusion has to be that fiscal policy may be revisited, with the current conventional wisdom on the need for debt reduction overturned in favour of fiscal expansion. That may be a long shot now but who would have predicted  a few year ago an ECB Funding for Lending scheme, forward guidance and a refinancing rate of 0.15%?

 

QE in the Euro area

Mario Draghi made it clear at  his press conference in early April that the ECB had no qualms about using QE if additional unconventional monetary policies were deemed necessary. The Bank may have come late to the party and asset purchases are not a given but the message has been reiterated over the past few weeks and that possibilty has been instrumental in driving peripheral bond yields in the euro area to levels few expected to see in a short time frame. The ECB is also more openly concerned about the euro’s relative strength  and its implications for the economic outlook  and some see QE as a means to weaken the currency, although the recent performance of the euro implies that not many in the foreign exchange market believe that QE is imminent or that it is negative -indeed traders have opened up speculative long positions in the currency.

In fact the  evidence on QE  elsewhere indicates that it can work through different channels and that it  may not precipitate a currency depreciation. Quantifying the impact of asset purchases is difficult as one can never know how the economy would have performed in its absence and expectations  can also  play an important role  but there are various statistical and econometric methods available which can at least give some approximations. The most recent work on the topic was published in a discussion paper by the Bank of England (‘What are the macroeconomic effects of asset purchases’, Weale and Wieladek, April 2014) comparing the effects of QE on the US and UK economies. The paper finds that QE does indeed have a significant impact on real activity and inflation, with asset purchases equivalent to 1% of GDP having a much bigger impact on real GDP in the US (a rise of 0.38%) than in the UK (0.18%) although a similar impact on inflation ( 0.38% in the US versus 0.3%)

The study also found that QE impacted the respective economies through different channels. The US is far less dependent on bank credit than the UK and longer term interest rates on financial instruments are much more important. Consequently, QE’s impact on longer term bond yields appears to have been the decisive channel in the US. In contrast,  the main impact  in the UK was through shorter term rates, which were  expected to remain lower for longer, and  reduced market volatility. The FX impact also differed; sterling’s real exchange rate was not seen to be affected by QE whereas the dollar did depreciate according to the study.

What are the implications for QE in the euro area?. Well, we know that the market for private sector bonds in Europe is not large so any purchases  by the ECB would probably concentrate on longer term government bonds (hence the rally of late) , although, again, shorter term rates and bank lending probably have a much bigger impact on the euro economy. That suggests that the impact on GDP would be nearer to the UK than the US experience and that  €1000bn in QE (around 10% of euro GDP) would boost GDP by some 1.8%. Inflation in the euro area is much stickier than the US or UK so one doubts if the CPI would rise by the  3% or more indicated by the BoE study. Nor is it  a given that the exchange rate would depreciate-indeed, by lowering the risk premium on peripheral bonds  QE may  actually support the euro.

Of course the ECB may decide to do nothing for a while longer, particularly given the prospect of stronger growth in the euro area in the first quarter, and in a sense the mere  promise of QE may have already achieved at least some of its aims. An actual announcement may  therefore  risk disappointment and lead to some selling of bonds  ( ‘buy the rumour. sell the fact’) . So if the ECB does want a weaker euro, negative interest rates might well prove a better bet  than QE given the mixed results elsewhere.

The Future of the Euro

I was recently involved in a panel discussion on the euro at  the Cass Business school on March 3rd 2014, hosted by the London Irish Graduate Network. Tadhg Enright was in the chair and the other participants were  Graham Bishop and Martin Wolf from the FT.  Although there were no set speeches I took the opportunity to gather some thoughts on the euro, produced below.

The euro is now well into its second decade, having survived what appeared to be an existential crisis, and by most attributes of a sound currency can be viewed as a success. This is particularly true for the euro as a store of value; its internal purchasing power has been supported by stable and low inflation around 2% per annum and its external value has also been broadly maintained over time-the trade weighted exchange rate is currently about 5% above its level at birth according to BIS data. Yet few would argue that the original eleven members fulfilled the criteria normally required for an optimal currency area and the economic performance across those countries has hardly been uniform; Finland recorded a 20% rise in real GDP per head from 1999 to 2013 according to IMF data, followed by Germany (19%), Austria and Ireland (18%), in contrast to the zero growth experienced by Portugal over that period and the 3% fall seen in Italy. Of course we will never know how they would have performed absent the euro but it is clear that monetary policy at least has been far from optimal for individual countries- a simple Taylor rule, for example, would suggest that rates were far too low in Ireland in the first half of the noughties. Adjustments to imbalances are also clearly asymmetric, with the burden solely on debtor countries to shift resources to the external sector while creditor countries are not required to expand domestic demand to make that adjustment less painful. The notion of punishment for miscreants is a strong undercurrent in creditor country thinking and the penal rates on the original official loans from the Troika to those in bail outs were only abandoned as the threats to solvency became stark.

Differences in regional growth rates are not unusual of course and can persist for long periods. One can point to the fifty US States as an example, although a shared culture, language, legal and education system allows for mobility of labour and capital, which is not the case for the euro. The Federal budget in the US also acts as an automatic stabilizer, providing a partial cushion for weaker States in a way that is impossible in Europe given that the EU Budget is only around 1.5% of GDP.

Currency unions generally evolve from political initiatives rather than any compelling economic case and the euro clearly fits that model-remember all EU members are supposed to adopt the currency when meeting the entry requirements (although currently 2 have opt outs and a third, Sweden, an implicit opt out) which implies a membership of at least 25 over time, from the current 18. The flaws in the original construct have also been exposed: the monetary union created is part of an economic union but each country was left with fiscal sovereignty and control of its own banking system and, crucially, without a Lender of Last Resort such as the Fed or the BoE. Consequently the eruption of the global financial crisis from 2008 put huge stress on euro peripheral bond markets as, to some degree, those governments were borrowing in a ‘foreign’ currency, backed only by their ability to raise tax revenue in euros, as they had no mechanism to print euros to meet debt obligations. The ECB and the main government players also saw the explosion in fiscal deficits as the cause rather than a symptom of the crisis and confused investor concern about specific credit risks with an attack on the currency, pledging that ‘no euro bank will default’, so compounding the sovereign debt issue and the ‘doom loop’ between sovereigns and banks. That view had a particularly profound implication for Ireland, with the State injecting €64bn or some 40% of GDP into the banking system, with equity holders and sub-debt holders shouldering some of the bank losses. Ireland also had ‘first mover disadvantage’ as it is now proposed that senior debt holders can be ‘bailed in’, a policy then prohibited by the ECB.

The euro crisis precipitated a series of emergency, ad-hoc and sometimes contradictory policy responses  by the Eurogroup and the ECB, with the latter eventually promising to do ‘whatever it takes ‘ to save the currency, including  a conditional pledge to buy secondary market sovereign debt in unlimited amounts, in contrast to the misconceived and half-hearted Securities Market Programme. The commitment has never been tested but the market response indicates that investors probably perceive that the euro now has a Lender of Last Resort, at least of a sort, and is comforted by that fact, shrugging off doubts about its legality and degree of support within the Governing Council, although that sanguine view may change as events unfold. The fall in peripheral bond yields  may also be driven by investors giving some probability to  QE eventually emerging from the ECB.

The conventional view among commentators is that the euro project has now to evolve into a banking union and ultimately a full fiscal union. Steps have been taken in terms of the former, albeit hesitant ones, with the burden of bank resolution still State dependent for up to a decade. The tide of public opinion in Europe also appears to have shifted away from Federalism and so the concept of debt mutualisation is a long way from realization. Moreover, new euro fiscal rules will further limit discretionary budgetary policy within member states, so leaving governments and hence electorates with no macro tools to affect aggregate demand; domestic policy levers can now solely impact the supply side of the economy given the loss of sovereignty over fiscal, monetary and FX policies.

The conventional wisdom on banking and fiscal union requires political agreement on the way forward and it is by no means certain that electorates will support these moves. Indeed, the risk remains that debt fatigue or creditor fatigue will eventually result in the election of governments willing to risk leaving the single currency even though the costs of exit are seen as high and the outcome uncertain. What would Ireland do, for example, on a break up- a floating punt is unlikely so would it anchor again with sterling or adopt some range against the DM, as in the ERM? That uncertainty and perceived costs of exit may well continue to trump discontent within most or all the debtor members of the euro and the stagnation evident in the French economy may help precipitate a more expansionary monetary and fiscal mix in Europe – the respective performances of the US and UK economies relative to the euro area since the Great Recession surely cannot be put down to supply side responses alone.  One can never say that the fear of euro exit will always be the case, however, and that the single currency will inevitably survive in its present form.  Yet it is foolish, as some have done, to predict the date and time of exits as it will be political events that will determine the euro’s fate, which is appropriate for what is, after all, a political construct.

Press Conferences, the ECB and the Fed

The ECB and the Fed differ at many levels, including their respective mandates (the latter is charged with  maintaining full employment as well as price stability ) and the frequency of policy-setting meetings (one a month for the ECB but only eight a year for its US counterpart). The Fed’s Open Market Committee, which sets monetary policy, has twelve voting members and releases minutes of its deliberations, including the voting pattern, whereas the ECB Governing Council’s  membership is double that, with no published minutes, at least to date. They do have one thing in common though- press conferences hosted by the Head of the institution- although the Fed has only recently adopted that practice and limits it to one a quarter, as against the ECB’s regular slot on the first Thursday of the month.

The press conferences also differ markedly however. Ben Bernanke has held court at all of the Fed’s to date, and things may change when Janet Yellen takes over, but  there is a much more open  atmosphere than in Frankfurt and it probably reflects more than the personalities involved. This may in part be due to the nature of the audience, which is smaller in number than for the ECB and made up largely of ‘Fed-watchers’, who like the Kremlinologists of old are attentive to the slightest hint of any change in policy. Few, if any, foreign journalists appear to be present and the questions are usually to the point and illicit equally straightforward responses from the Chairman. One senses that there is an implicit belief that the population have a right to know what the Fed is thinking and the questioners seek to tease out any areas where there is a lack of clarity, although of course central bankers are not omniscient and any statement of intent is always contingent on events.

The ECB conference is more formulaic ( the President opens by reading a much longer statement than that issued by the Fed ) and the atmosphere feels very different, at last as viewed on television,  with the ECB President often striking a defensive and sometimes peevish tone, with attempts to justify past policy decisions (‘ the events of the past month have vindicated our  stance’). One is always left with the impression of an audience seeking to illicit answers from a Bank reluctant to elaborate,  which leaves an unsatisfied taste. A good case in point is OMT, which is regularly raised and is met with the response that all has been explained at some earlier meeting  although if that were the case the question would not arise. The sheer numbers involved in setting ECB rates inevitably makes for differing views in the Council and that may explain the President’s  caution in response to some questions but at times the dichotomy between the Bank’s  current stance  and its stated policy aims is glaring; the ECB is  forecasting inflation in 2015 at 1.3%, for example, which does not appear consistent with its definition of price stability (‘below but close to 2%’) and implies monetary policy is too tight, even after the recent rate reduction.

Monetary policy in the euro area is  certainly more pragmatic under Draghi and the ECB has moved a long way from its Bundesbank-centred roots. The  press conference has  also ditched some of  the rituals common in President Trichet’s time, when everyone listened for some key words, like ‘strongly vigilant’, as a signaling mechanism- what’s wrong with saying  that ‘ we are likely to raise rates at the next meeting in the absence of unforeseen events’ rather than use some code?. The questions  also vary in quality and relevance it also has to be said, with some journalists seeking comments on specific country issues which are beyond the remit of the ECB (‘Draghi praises Ireland’s/ Portugal’s/ Italy’s/  stoic adherence to fiscal rectitude’). One final point. President Draghi’s pledge ‘to do whatever it takes to preserve the euro’ was queried by a (German) journalist at one press conference, with the latter pointing out that Governments and ultimately electorates would decide the single currency’s fate. An unusual intervention , highlighting that the ECB is ultimately accountable to the citizens of the  euro area, and that it is their Central Bank.