Investors are poised for this Thursday’s expected announcement of a massive Quantitative Easing (QE) programme by the European Central Bank (ECB). The market has long expected a European QE and has been pricing the move into markets; it has for example crunched European bond yields.
Figure 1. Euro area 10-year Government Benchmark bond yield
It is difficult to anticipate how markets will react; QE could already be priced into asset prices. So when it’s announced nothing may happen or possibly prices may actually fall. But as value investors we want to look through short-term volatility, and step back and consider the longer-term impacts of such moves.
Basically, we believe a European QE is a bailout in disguise.
The first point to make is that a European QE could be too late; that the Europeans have been too slow with QE. It’s important to remember that it is now seven years since the height of the global financial crisis (GFC), and six years since it ended; yet we are still ‘working through’ the fall out of the GFC, but seem nowhere near a solution in Europe.
Why would it work now?
The second point is that we are sceptical of the economic impact of QE. Around the world QE has failed to generate credit growth (see Japan and USA); instead the liquidity has been used, not for consumption, but for asset-price speculation. It hasn’t worked in the past, why would it work now?
We suspect that after Thursday’s announcement, the market will experience some volatility; but then investors will come to the conclusion that it is not a total solution and more is required in fiscal policy.
Any economic impact of QE will be through further depreciation of the euro. The euro has already fallen around 20 per cent against the $US in the last six months. Further falls will boost Europe’s manufacturing and export sector. But it will also hurt US multinationals with significant earnings in Europe, who will see their profits decline. How will the US react? And how will the Chinese react? Will they too depreciate the yuan against the $US?
A secret bail out
The most interesting aspect of Thursday’s announcement will be what the ECB says about the structure and purpose of QE. We suspect the ECB will buy higher-yielding bonds, which means buying sub-prime bonds from the likes of Greece and Cyprus.
Because of the lack of economic stimulation that would create, we believe that the QE program only makes sense if the money is printed, the bonds bought, and then that debt eventually forgiven as part of the renegotiation of debt in Europe. Basically, the ECB is buying debt off countries that can’t pay it back. Of course, if that is the goal, the ECB will never state it publicly.
So, watch for the bond market moves in the sub-prime sector of the European bond market. Then watch to see if the European Union encourages governments to increase fiscal deficits. It is fiscal policy that will jump start growth with a weakening Euro then generating export growth. However, is printing currency complying with free trade agreements or is it an abuse? That is one question that no one wants to ask.