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How ECB quantitative easing might work

One answer might be for the European Central Bank to begin quantitative easing in the name of monetary policy transmission to stave off deflation, rather than of capping government bond yields or anything else that smacks of financing governments

Market commentators are still struggling to decide how much significance to attach to yesterday’s failed German government bund auction. Rates strategists at Deutsche Bank suggest it showed investor resistance only to yields driven to record lows by Germany’s safe haven status. It did not reveal serious concerns about the country’s credit fundamentals. Had yields been just a few basis points higher, bids would have been much stronger.

But even the sanguine Deutsche bank analysts sound jumpy: 

“It’s hard not to see the irony in the fact that the Bundesbank yesterday ended up effectively ‘buying’ €2.356bn of the technically ‘failed’ €6bn 10-year German auction. After the last couple of weeks of increasing opposition to more aggressive ECB intervention, the Bundesbank/Germany must surely now start to be concerned that their intransigence is part of the reason the crisis is now even hitting the core. The auction is a warning sign to Germany that a continued hard-line stance might be counterproductive even if all possible alternatives will only encourage moral hazard. Germany is stuck between a rock and a hard place, and yesterday may accelerate some of their thinking.”

Barclays’ analysts take a more guarded view, suggesting the auction raises another red warning flag: 

“The auction highlighted the risk of yet further contagion from peripheral Europe to financially stronger European sovereigns.French, German, Italian, and even Dutch bond markets weakened substantially yesterday. Italian 10-year yields are once again close to 7%, despite continued ECB intervention in euro area bond markets.”

Meanwhile, Gary Jenkins, head of fixed income at Evolution Securities, comes up with an intriguing read-across to possible future ECB action: 

“[Mario] Draghi has called for urgent action by politicians and the ECB is clearly a reluctant buyer of sovereign debt which limits the effectiveness of its purchases. It seems to us that Draghi would be better off going for one of two extreme options: either scrap the notion that bond buying is limited and temporary, and announce that it is unlimited and for as long as it takes (maybe with targeted spreads over bunds) to try to restore market confidence and to encourage investors to buy alongside the ECB; or they can tell the politicians they have to solve the crises and tell them (privately) that they will cease all bond buying at a specific date. That should concentrate the mind wonderfully and also acknowledge the fact that the ECB’s current half-hearted strategy isn’t working.”

Maybe there’s another way to look at this.

Maybe the ECB thinks its policy is working perfectly. For many central bankers on the ECB governing council, the last couple of weeks must look like an extraordinary success. Government bond yields have risen to the point where politicians finally realize the seriousness of the situation. Three new governments in Italy, Greece and Spain are making early efforts to enact measures to consolidate public finances and will hopefully follow these up with structural reforms to improve competitiveness. The ECB might be congratulating itself that its bond buying through the SMP has been just sufficient to prevent outright financial catastrophe but limited enough to avoid moral hazard. It has compelled governments to act.

But what happens next if eurozone governments take what the ECB considers to be the correct steps and yet investors continue to abandon the dysfunctional and illiquid government bond markets? Next year, governments have huge volumes of financing to do on the primary markets and may lock themselves into an inescapable debt trap if they have to complete it at very high spreads.

One answer might be for the ECB to begin quantitative easing in the name of monetary policy transmission to stave off deflation, rather than of capping government bond yields or anything else that smacks of financing governments. After all, the traditional offset for tightening fiscal policy is looser monetary policy, and ECB policy rates are low already. Moreover, the transmission mechanism through government bond markets is even more broken now than when the ECB first began buying government bonds in May 2010.

Rather than just targeting the periphery under quantitative easing, the ECB would probably have to buy across a representative sample of the eurozone government bond markets, perhaps based on its own capital key, which heavily weights Germany and France. If it was feeling a little cheekier, it might propose buying according to a European government bond index that would give greater weight to Italy. For the ECB to enact such a policy of quantitative easing, the economic outlook would have to appear grave indeed. The central bank would also no doubt require abundant political cover, including an undertaking by the council of ministers to indemnify it against losses born during the undertaking of extraordinary monetary policy measures.

The experience of the Bank of England suggests that if the policy of quantitative easing works and if it restores confidence to bond markets – even as debtor governments consolidate finances and enact structural reforms to boost growth in the longer term – then the ECB might even make a profit. Of course, those are two big ifs. Perhaps more significantly, the Bank of England experience also suggests that once a central bank establishes a policy of quantitative easing, the size of any such programme can be increased relatively easily.

- Euromoney Skew Blog

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