Whatever It Takes

This week, the European Central Bank opened the next chapter of central bank intervention in capital markets with the launch of a large-scale quantitative easing program. ECB president Mario Draghi announced that starting in March the Eurozone central banking system will purchase 60 billion euros of government and agency bonds every month at least until September of next year. Importantly, he indicated that the 1.14 trillion (!) euro monetary stimulus program may be increased or lengthened if inflation in Europe remains below the ECB’s 2% target.

Europe’s economy has stagnated under the weight of its high debt levels and its slow-growing and aged workforce. Will the central bank’s action give birth to sustainable drivers for economic growth such as new business formation, capital investment, and innovation? Probably not, if the historical record of QE persists. The help to the US economy from QE in the last few years is debatable, and Japan has used QE off and on over the last two decades to no effective end.

Liquidity conditions will, however, improve as massive amounts of low-risk assets are taken off the open market, forcing investor capital into higher-risk categories. Therein lays a main effect of QE – an increase in excess liquidity that suppresses volatility, encourages risk taking, and drives up prices in capital markets.

Fixed income markets have already priced in some of QE’s effect, with yields of German, French, and Dutch government bonds trading at a negative yield at five-year maturities. Currency markets are also reflecting the monetary intervention, with the Euro down 19% versus the US dollar from a year ago and trading at an 11-year low. Japan with its own QE program has driven the Yen down 14% versus the US dollar from a year ago to a seven-year low. Therein lays another main effect of QE – currency devaluation that has the dual aim of improving industrial export competitiveness and inflating away the real value of a country’s debt.

Mario Draghi famously announced in 2012 that the ECB would do “whatever it takes” to save the Eurozone from breakup and economic stagnation. He added the flourish “Believe me, it will be enough”. At best, the ECB’s action can serve as a salve, buying time with low rates and stronger exports for Europe. As with the US implementation of QE, we expect financial markets to meanwhile benefit from these temporary measures.