THE DECISION
Earlier today, the ECB announced a monthly EUR 60 billion per month quantitative easing programme, which Mr. Draghi said will continue until September 2016. He also commented that purchases canpotentially continue until inflation expectations rise towards the 2% target. The additional sovereign purchases were not mutualised (with the exception of agency debt), which Mr Draghi characterised as an attempt to mitigate the fiscal implications of QE policy. In terms of size and other parameters, the programme was certainly towards the dovish end of market estimates and the explicit linkage to inflation expectations suggests there is scope for further extensions to the programme.THE BACKDROP
The adoption of the easing programme has been slow compared to other advanced economies, given the philosophical and political issues within the ECB’s governing council. Specifically, it has taken a lot of time (and weak data) to convince the German contingent that QE is required to improve economic outcomes in the eurozone. The region is now in deflation (latest print of -0.2% yoy) and the growth outlook looks both uneven and anaemic.
Until recently, the German bloc led by Mr. Weidman (supported by Ms. Merkel) had continued to argue that QE will blunt individual government incentives for reform. In addition, there had also been a sharp debate on the risk-sharing front, where the prospects of national central banks (rather than the ECB itself) buying the respective sovereign paper had been raised. Technically, whether the risk sits on national central banks or the ECB matters less from a practical point of view, but it does signal the health of the current political consensus.
The ECB decided to not risk-share additional sovereign purchases but Mr. Draghi spent a lot of time defending this decision and differentiated between application of monetary policy versus crisis fighting (i.e., he said Outright Monetary Transactions (OMT) are risk-shared so mutualisation is an integral part of ECB policy).
WHAT IS QE SUPPOSED TO ACHIEVE?
The main transmission channel through which ECB intervention is supposed to work is through the signaling effect on inflation expectations. Whether this can be achieved remains to be seen. Real yields are already quite low in the eurozone (-0.3%) and recent monetary policy easing moves have been met with little success as inflation expectations (both survey and pricing) have continued to fall. Indeed, the latest downshift has come at a time when inflation expectations have fallen across the world on the back of falling oil prices.
Despite the stronger than expected programme announced today, the longevity and size of the impact on inflation expectations remains to be seen, given the combination of structural and cyclical issues facing the eurozone economy.
The second important goal of deploying QE is to ease financial conditions further. The ECB had built an expectation of easing in recent months and this has already done a significant part of the job (so the surprise factor is weaker) as eurozone yields have fallen sharply over the last six months. In addition, the weakness in the euro further adds to the easing of financial conditions that has happened to date. Given how low rates are already, we think the more dovish than expected programme will continue to manifest itself in a weaker euro.
EUROPEAN FIXED INCOME AND FX OUTLOOK
Support for European fixed income (both sovereigns and corporates) looks likely to remain intact after the announcement of the programme. Interest rates will have to remain low or go lower in order to provide the necessary stimulus to the economy. Given structural issues and faulty transmission channels, we think the ECB will have to continue with asset purchases for the foreseeable future, particularly as deflation is likely to worsen in coming months to keep pressure on rates and FX intact.
Salman Ahmed, Global Strategist, Lombard Odier
