The extent of the European Central Bank's (ECB's) quantitative easing (QE) program must be seen as a positive surprise after the European Court of Justice (ECJ) gave the 'green light' for sovereign bond buying, if used for monetary policy purposes.
Fundamentally, the program seems to tick all the boxes for the market. The program contains a conditional open-ended commitment; limitation of risk sharing; sovereign buying of maturities out to 2-30 years; acceptance of the ECB's pari passu treatment to private creditors; and purchases of sovereign and European institutional debt conducted according to the ECB's capital key. Bonds purchased by the ECB must be at least investment-grade, but Greek bonds are not necessarily ruled out as "some additional criteria will be applied to program countries." The ECB may buy not only bonds with negative yields, but also indexed debt.
What does this mean for interest rates and currencies?
- The ECB's bond-buying program will affect liquidity conditions in European markets, particularly the German bund market. This is due to the large percentage of reserve and passive managers invested in the European bond market (especially German bunds), compared with the US Treasury and Japanese government bond markets, which limits the amount of the free float. The question is: unless these long-term holders change their strategies, where will the ECB source the bonds from? The extent of the ECB's QE program is also substantial compared with the US Federal Reserve (Fed) and Bank of Japan's programs when considering its size as a percentage of new issuance, or even the outstanding supply of total German bunds. This may limit the program's effectiveness.
- The ECB's purchase of bonds in European markets will send European real interest rates lower, but the main purpose of the program is to stabilise and drive inflation expectations higher. Therefore, the effect on nominal bond yields is largely indeterminate, although the initial reaction should see yields fall below already historically low levels.
- The Euro will likely weaken, which is what QE programs are largely designed to do. The depreciation will be driven not only by an expanding ECB balance sheet, but also by lower European real rates and higher inflation expectations.
- The QE program should be good for risk assets as the lower currency should help boost the European economy.
- The fall in real rates should, however, affect those countries with higher real rates, helping to support their currencies. Consequently, the US dollar (USD) will keep rising, especially if the market expects the Fed to tighten rates, which will push up US real rates across the curve. Countries outside of the Euro system but pegged to the Euro have already started to react to the expected more-comprehensive European QE program by cutting rates to prevent their currencies from appreciating against the Euro. Those countries with high real rates may face similar issues.
- The general rise in the USD has lowered inflation in the US and has been a major driver of the fall in inflation breakevens in the US Treasury market, with nominal bond yields falling since July 2014. Therefore, the Fed's decision on when to increase interest rates is likely to be dictated by the impact of the higher USD on inflation, rather than growth, although the US economy is more exposed now than it was in the past.
- Markets have already reacted to expected tighter USD liquidity and this is often cited as one reason why commodity prices in USD terms have been falling in addition to increased supply and reduced demand. Will the ECB's actions add to global liquidity even if the Fed is tightening USD liquidity? What impact will this have on commodity markets? Prices may fall against the USD but actually still rise based on a basket of currencies if global liquidity is a major driver.
Obviously the major question is, will this program work given the European model of debt creation is via the banking system and not the bond markets? QE is generally deemed to have been successful in the US, but inflation still remains below the Fed's target.
Time will tell, but a major sustained bond sell-off is likely to hinge on the ECB's success, rather than when the Fed decides to increase interest rates. If the program is successful, German bund yields should rise and unhinge support for the US Treasury market. Otherwise, low European yields should remain supportive of US long yields and thus limit any sell-off caused by Fed tightening.