Quantitative Easing - A Question of "When" not "If"

Europe has found itself in a long hard grind back to economic normality with the European Central Bank (ECB) conducting a variety of monetary measures in order to safe guard the economic recovery of the euro-area. The banks decisions to create further stimulate programmes has weighed significantly on the pair with EUR/USD falling from above 1.3900 to the current 1.2300 handle in a little over six months. Although countries such as Portugal, Ireland, and Greece are starting to exit from their respective sovereign bailout programmes, their recoveries are not yet assured, and with the recent slowing of the European economic engine, Germany, the prospect of a deflationary scenario in Europe is mounting. So much so that the ECB may need to act once again in order to support growth.

Back in June this year, the ECB decided to take the unprecedented step of taking their deposit rate negative for the first time in the central bank’s (CB) history in an attempt to force banks to lend as they would be penalised for depositing cash with the CB. This methodology was maximised further with another 10bps reduction in September to take the rate to the current -0.20%. However, embarking on this route has now meant that the ECB have exhausted the use of the interest rate tool and has prompted President Mario Draghi to state explicitly in the most recent press conference that interest rates are now at their ‘lower bound’, a code language to the market that this policy option has run its course. Given that interest rates are now at their lowest possible level, the ECB has embarked upon several other measures in recent months, including the purchasing of covered bonds and the commencement of buying Asset Backed Securities (ABS). While this may buy the CB more time it remains to be seen whether these measures will have their desired effect. The bank is already believed to be studying the possibility of buying corporate debt directly in a move that would be highly beneficial for the smaller Italian and Spanish banks, the countries that showed the largest amount of casualties in the recently revealed European stress tests.

In a testimony to European lawmakers in Brussels, Draghi stated that an expanded purchase program could include government bonds. Separately, Luxembourg council member, Yves Mersch, has been quoted as saying that unconventional measures could theoretically include buying state bonds or other assets such as gold, shares or ETFs. As such, it would seem that even the most hawkish leaning members, i.e. such as Mersch, have started to side more with the idea of an expansionary balance sheet in order to deal with the threat of deflation in the Euro-area. Most recently President Draghi said that the central bank must drive inflation higher quickly, and will broaden its asset purchase programme if needed to achieve that, while he also paid note to the positive effect that bond buying programmes have had in the likes of the UK and US.

The idea of full blown Quantitative Easing (QE) is widely seen as a final option that the ECB has available in its ‘tool kit’. Policy of this nature is seen as a method of last resort for several reasons: The ECB still has other unconventional programmes to run their course and to see whether they will have the desired effect in order to avoid the so-called ‘bazooka’ option. This includes the purchasing of covered bonds and ABS, of which the CB may look to expand if the market believes that such measures are working. The ECB is still to conduct their second Targeted Long-Term Refinancing Operation (TLTRO), which is due in December, and with the stress tests now out of the way, the operation may see a bigger take up and help boost the capacity of banks to lend. An extension of this programme could come in the form of a relaxation in the terms of the operation in which less well capitalised or lower rated companies could participate in the offering. Starting QE would be against the existing Maastricht Treaty signed back in 1992 when the Euro bloc was created. According to the Treaty, EU member states are not allowed to finance their public deficits by printing money and as such any outright QE would require parliamentary approval in each individual Euro-zone country, a process that would undoubtedly take a significant period of time. This process would also find tremendous difficulty in obtaining parliamentary approval in countries such as Germany who are opposed to financing the debt burden of other weaker nations such as Greece, Portugal, Ireland, Italy and Spain. If the ECB did commence QE then it would leave very little policy options going forward, and if the programme were not to succeed then the ECB could quickly find themselves expanding their balance sheet well above levels that would be sustainable over the long-term.

The idea of full blown Quantitative Easing (QE) is widely seen as a final option that the ECB has available in its ‘tool kit’. Policy of this nature is seen as a method of last resort for several reasons:

  1. The ECB still has other unconventional programmes to run their course and to see whether they will have the desired effect in order to avoid the so-called ‘bazooka’ option. This includes the purchasing of covered bonds and ABS, of which the CB may look to expand if the market believes that such measures are working.
  2. The ECB is still to conduct their second Targeted Long-Term Refinancing Operation (TLTRO), which is due in December, and with the stress tests now out of the way, the operation may see a bigger take up and help boost the capacity of banks to lend. An extension of this programme could come in the form of a relaxation in the terms of the operation in which less well capitalised or lower rated companies could participate in the offering.
  3. Starting QE would be against the existing Maastricht Treaty signed back in 1992 when the Euro bloc was created. According to the Treaty, EU member states are not allowed to finance their public deficits by printing money and as such any outright QE would require parliamentary approval in each individual Euro-zone country, a process that would undoubtedly take a significant period of time. This process would also find tremendous difficulty in obtaining parliamentary approval in countries such as Germany who are opposed to financing the debt burden of other weaker nations such as Greece, Portugal, Ireland, Italy and Spain.
  4. If the ECB did commence QE then it would leave very little policy options going forward, and if the programme were not to succeed then the ECB could quickly find themselves expanding their balance sheet well above levels that would be sustainable over the long-term.

In summary, the ECB are expecting to continue using their existing policy instruments and if further stimulus were required in order to tackle falling inflation, then a relaxation or further expansion of current programmes would be expected. In this scenario, the ECB would look to utilise its well-honed skills in communication and strong track record of appearing transparent in relaying their latest thinking to the market via day-to-day council member commentary and a monthly press conference. All of these methods provide a trading opportunity in an intraday fashion with longer term plays possible should the central bank look to become more creative in introducing new policy measures. Any outright signal of QE may become a reality in Q1 next year so key data points to watch in the meantime will be focused upon inflation and on the ability of the German economy to sustain its economic momentum. It is interesting to note is that one of Goldman Sachs’ (GS) top recommended trades for 2015 is for EUR/USD to fall to 1.15 over the next 12 months, in equal parts a reflection of a bullish USD view and bearish EUR outlook. In particular, GS say that given that HICP inflation is unlikely to rebound in coming months, there is a chance that additional ECB easing, including possibly sovereign QE, comes sooner rather than later, setting the stage for the pair to move meaningfully lower in the short term.

In terms of how the market reacts to fundamental news from the ECB, it is not uncommon to see a 20-30 pip move if a pertinent ECB or source comment is broken by the major news wires and during the regular monthly ECB press conference price swings in excess of 100 pips are a regular occurrence. Given that the ECB is made up of 24 individual council members each representing their own domestic central bank, a normal trading day will often have two to three members scheduled to speak during each trading day, therefore a keen eye on the schedule of speakers is of the utmost important. Also, in order to trade the currency effectively, one must also monitor movement in the EUR/GBP and EUR/CHF crosses, of which any technical breaks can have an impact on the major pair itself. The latter is particularly important as it trades in very close proximity to a predetermined floor that the Swiss National Bank (SNB) actively protect (1.2000) in order to stop their local currency appreciating. Finally, another good lead indicator as to gauge the sentiment intraday in Europe is to monitor the performance of the peripheral bond yields and their respective stocks indexes. The Italian FTSE MIB and the Spanish IBEX often act as the outlying indices as their banks are more sensitive to fluctuations in interest rate expectations and often act as a good measure for EUR appetite.