Quantitative Easing: The Emporer Has No Clothes
The European Central Bank stimulus package of 10 March exceeded market expectations; markets rose, then fell again the same day. Market players are concluding that Quantitative Easing doesn’t improve economic prospects and are edging closer to withdrawing their capital from this risky global game of overpriced equity and bonds. When they do run for safe assets, the cost of all our cheap debt will rise to match the real risk of repayment, not today’s public fantasy.
Most investors probably never believed that fantasy anyway, they are just profiting from the power of large investment funds to manipulate and profit from global volatility, especially currency movements. But the endgame for quantitative easing is closely linked with the prospects for national currencies and the future economic prospects of every nation.
So let’s return to the beginning in more detail and unpack what it means. Thursday’s ECB measures included a series of rate cuts, additional bond purchases and ultracheap loans for banks (some will be paid to borrow). Initial market enthusiasm faded as soon as ECB president Mario Draghi advised interest rates probably would not fall any lower due to concerns about the impact on Europe’s fragile banks (and retirement funds).
After initially rising following the broader than expected package, European stock markets fell and the euro soared. Frankfurt’s stock index closed down 2.3%, Paris ended 1.7% lower and the FTSE 100 slid 1.8%. The euro initially fell 1.6% against the US dollar to $1.0822 before jumping as high as $1.1218. This was one of the biggest one-day swings in the currency’s history.
Here’s a selection of the more revealing comments from market participants:
“They gave the market a gift and then took it away within an hour,” said Eddie Perkin, chief equity investment officer at Eaton Vance Management.
Simon Derrick, chief currency strategist at BNY Mellon summed it up: “If the intention of the ECB board was to help weaken the euro then their work was entirely undone by Mr Draghi’s comments about the future path of rates.”
“It’s hard to see even lower rates and more QE in Europe as a positive development. The fact the ECB is still pursuing such extreme monetary policy paints a depressing picture of the European economy, and markets are beginning to question what central banks have left in the locker if the global economy slips back towards recession” said Laith Khalaf, senior analyst at Hargreaves Lansdown. The ECB was now “plumbing the depths of monetary policy in a bid to stave off the encroaching threat of sustained deflation in Europe”.
The ECB’s latest move “will probably simply continue to benefit primarily the financial markets but do little to alter low growth and low inflation,” siad Joerg Kraemer, chief economist at Commerzbank.
Karen Maley in the Australian Financial Review provided the following analysis:
“The expected move by the ECB to push interest rates even deeper into negative territory comes despite howls of protest from banks and insurance companies, which argue that negative rates are undermining their business models. Retirees and other savers are also opposed, arguing that negative interest rates will further erode the already paltry returns they earn on their investments.
Even borrowers – who are supposed to be the biggest beneficiaries of negative interest rates – are sceptical. Mortgage costs are rising in Switzerland, a country that has been experimenting with negative interest rates for more than a year, as banks have decided not to pass on the cost of negative deposit rates to their retail depositors, and have instead pushed up home loan interest rates. There are also worrying signs that credit costs appear to be moving higher in Germany, France and the Netherlands.
And economists, who have long hero-worshipped central bankers for rescuing the global economy from a deep recession after the financial crisis, have started to question whether they’re now overstepping the mark. Some even contend that their policies are stoking the next financial crisis.
So what makes central bankers in Europe and Japan so determined to proceed with such controversial policies? Encouraging inflation is a huge priority in Europe and Japan because it helps reduce the pain of massive debt burdens. This is a major factor in Japan, where public debt stands at a staggering 245 per cent of GDP, and in the eurozone, where it is 91.6 per cent on average.
Negative interest rates are helping to lower borrowing costs for governments. Countries such as Spain and Italy have seen two-year bond yields drop below zero, whereas Germany has benefited from a collapse in its borrowing costs.
But even more importantly, negative interest rates are just the latest and most effective weapon in the global currency war. Since the financial crisis, central bankers have been covertly using monetary policy to drive exchange rates lower
When it launched its massive bond-buying program (known as quantitative easing, or QE) in early 2015, the ECB was acutely conscious that, by increasing the number of euros in circulation, the single currency would fall, which would give a handy competitive advantage to European exporters. And the plan worked. Between mid-2014 and mid-2015, the euro fell about 10 per cent against other countries.
Similarly, one of the big advantages of negative interest rates is that they encourage capital to move to other countries that offer more attractive returns, and this capital outflow helps to push currencies lower. That’s why the ECB, the Bank of Japan, as well as central banks in Switzerland, Denmark and Sweden are so enthusiastic about negative interest rates. It’s a new form of monetary war.
And it seems to be working. The demand for Japanese bonds has been intense since the Bank of Japan unveiled its negative interest rate policy at the end of January. On Tuesday, the yield on 10-year Japanese bonds fell to a record low of minus 0.1 per cent on Tuesday. (Yields fall as bond prices rise.) But ever lower bond yields are encouraging Japanese investors to buy foreign bonds. Outflows into foreign bonds during the two weeks to February 26 hit the highest level in four years.
The problem is that, in a system of floating exchange rates, one currency can only fall if another rises. And given weak global demand, no country wants a stronger currency.
This includes the United States. Although the Fed tolerated a rising US dollar last year, the greenback’s strength is clearly hurting American exporters. And this is likely to persuade the US central bank, which in December raised interest rates for the first time since 2006, to keep interest rates on hold at next week’s meeting.
Meanwhile, many analysts believe that, faced with dwindling exports, China will have no choice but to allow the yuan to fall sharply – which means that the global currency war is about to get a lot hotter.” (source: AFR)
Unfortunately, all this stimulus by powerful large economies disadvantages smaller and developing nations. In today’s export-driven world, this has serious consequences – falling competitiveness, rising costs for private and public debt repayment.
Incidentally, don’t you get tired of hearing economists talk about the importance of meeting “inflation targets”? Deflation is just a code word for weak economic demand and poor economic prospects. It makes a serious problem sound like a technical issue, one which a technical solution like QE might solve.
Poor economic prospects and high levels of debt will take more than money-printing to fix.
“It’s hard to see a way out [of this era of ultra-loose monetary policy],” AllianceBernstein’s John Taylor says. “The good thing about QE is that at the depths of the crisis it stops things getting any worse, but the downside is the recovery is slower, forever after almost, because of that debt overhang. So you need to clear out that debt at some point.”