Today, the European Central Bank (ECB) announced that its Quantitative Easing (QE) programme will be extended to include large scale purchases of 2 year to 30 year eurozone government bonds in the secondary market. The ECB had previously restricted its QE programme to purchases of only private sector assets, namely covered bonds and asset backed securities. Today’s decision to include eurozone government bonds came almost six years after the Fed’s initial programme, and shows how difficult it has been to overcome the ECB’s unwillingness to finance governments for fear of breaching EU Treaties banning “monetary financing”. There remains deep-rooted opposition to QE within the ECB, with dissenting views likely to have come from some members, including the Bundesbank’s Jens Weidmann. However, the QE decision was supported by a majority of members who were more concerned about the eurozone’s recent slip into deflation.
The ECB will create new central bank money (or “print” money) in order to grow its balance sheet by €60 bn per month between March 2015 and September 2016, and this projected €1 trillion expansion in the size of its balance sheet is almost exactly in line with President Draghi’s previous statements. It has, however, become increasingly evident that with inflation currently negative, and with short and medium term inflation expectations falling, more aggressive monetary easing was required. The ECB’s desired balance sheet expansion cannot be accomplished without large scale purchases of government (and agency) bonds as the existing Covered Bond and ABS purchase programmes, although relatively new, has been progressing at a painfully slow rate of only around €10 bn per month.
The government bonds purchased by the ECB will be in proportion to member countries’ capital contributions to the Central Bank (ie broadly in line with their gdp weights within the eurozone). In a nod to market pressure, ECB ownership will rank equal to market ownership, thereby ameliorating concerns that the more the ECB buys, the more subordinated private holders may become. However, in the hypothetical event of a sovereign default, in a further nod to appease the Bundesbank, there will be limited sharing of risks. Twenty percent of the asset purchases will be subject to a regime of risk sharing, and 80% of the credit risk taken on will remain with each central bank and their respective sovereign. This mild disappointment will, for the time being, be trumped by the sheer scale of the ECB’s planned operations, as their purchases will exceed supply for the next two years. In other words, the free float of bonds in the eurozone will contract.
The ECB’s planned purchases, together with the Bank of Japan’s existing programme mean that over $100bn of new central bank money will be added to global financial markets each month, easily exceeding the peak $85 bn per month injected by the Fed prior to the tapering of QE3. This easing is on top of conventional rate cuts from the likes of the Bank of Canada, and the expected delay of Bank of England rate hikes well into 2016. The message from global central banks is that even after the Fed hikes rates as expected around Q2 or Q3 of this year, global liquidity will keep increasing. This will keep bonds well supported and, with inflation showing few signs of a sustained upturn, yields will remain low. This desire to own bonds should not be mistaken for a blind yield grab by market participants. Inflation is down and economic fundamentals are slowly improving; hence risks remain of being under-rather than being over-invested. Of course, as Draghi reminded us today, monetary policy on its own will be ineffective. It is now up to governments to put fiscal deficits and government debt on sustainable trajectories, and for structural reforms to boost growth and productivity.
One final point: will the market be willing to relinquish their positive yielding bonds for negative yielding cash? The ECB will have to pay up, and we remain overweight eurozone bonds in both the core and periphery.
Last week the Swiss National Bank (SNB) surprised the market in deciding to end the currency floor mechanism that had been in place since the eurozone crisis in mid-2011. The market reaction was large by any standards, ranging from a 90 standard deviation event compared to option pricing the day beforehand to a 30 standard deviation event compare to realised volatility through the 2007/2008 financial crisis period. For context, a 10 standard deviation is often considered as the most extreme scenario for risk analysis. While the SNB anticipated significant market volatility, and would have had information on the extent of market positioning that is not publicly available, it is likely that such an extreme move was still an unwelcome surprise.
For the rest of the world, the fate of the Swiss economy may not be a primary concern but the financial market linkages could have a global impact. Based on the latest Bank for International Settlements (BIS) data on over-the-counter (OTC) derivative positions, the notional exposure to Swiss Franc (CHF) currency trades and currency options was nearly $4 trillion at the end of H1 2014, reasonably similar to levels over the previous year. While there is considerable uncertainty around how much exposure may net out, we estimate an approximate range for the wealth transfer that occurred as a result of the CHF appreciation on Jan 15 to be between $100bn and $500bn. While some early casualties are attracting attention in the media, there are likely to be significant exposures on positions that will not settle for a couple of months and so we remain cautious of further turbulence in the markets.
At the same time as abandoning the currency floor, the SNB cut rates by 50bps to target LIBOR at -75bps. In order to gauge the relative impact of the trade weighted exchange rate, equity and yield moves we favour examining the overall impact on monetary conditions. Based on our analysis the effect of the currency move is significantly greater than the effect of lower rates, taking Swiss monetary conditions from levels that were reasonably stimulative to the tightest levels since the introduction of the currency floor in 2011.
The Swiss economy is not well placed to face such a large tightening of policy, with the SNB’s December monetary policy outlook forecasting four quarters of negative inflation even before the further impact of the latest oil prices declines are considered. The challenge for the SNB going forward will be how to stimulate the economy and prevent a serious economic decline.
With interest rates already below the cost of storing banknotes, it is not clear that further lowering of rates will be possible from a practical perspective. It would be natural to expect financial market participants to take the opportunity to borrow CHF at negative rates, place banknotes into storage and earn positive carry with little risk. Quantitative easing is a possibility, but with a small stock of government bonds available to purchase such a programme would likely have to focus on equities, and thus entail significant fiscal risks. The most likely reaction in our opinion would be to ask the government to provide fiscal stimulus, confirming the central bank is not able to operate monetary policy truly independently of the government. Indeed, it is this inability to avoid monetary policy imposing fiscal risks that endanger the wealth of the nation that is widely believed to be behind the decision to abandon the currency floor in preference to accumulating further foreign exchange reserves.