The risks the ECB knows it's running
Markets may crash when QE ends
by Stefan Bielmeier
Fri 13 Mar 2015
The European Central Bank is well aware that, through its quantitative easing programme, it is taking large risks with the functioning of capital markets and economies. It recognises the institutional shortcomings of the euro area and of its members’ governments, in particular their inability to make reforms – and this is the main factor forcing the ECB into action.
Unfortunately, a vicious circle is at work here. The QE programme and the fall in interest rates in its wake may hold back reform efforts. Yet continuing failure on this front would make structural differences between member countries ever wider. This would make it even harder for unitary monetary policy to function effectively – which would call into question the reason for the euro bloc’s existence.
The ECB is doing its best to fulfil its mandate in an inadequate institutional framework. Many on the ECB's governing council believe resolve is needed to secure the single currency’s long-term survival.
Should positive growth effects fail to materialise, and euro members’ divergences widen, the responsibility will lie not with the ECB but with national governments that are neither willing nor able adequately to adjust their economic policies.
The ECB is aiming to buy €60bn of bonds every month, more than €40bn in euro area sovereign bonds. German government securities make up around 25% of the planned bond purchases.
The ECB appears prepared to pay a high price. Mario Draghi, the ECB president, has announced that central banks will buy bonds yielding above the bank’s deposit rate of -0.2%. It is unusual for a buyer to state both its target quantity and maximum price in advance. There is no reason why potential sellers should sell the ECB bonds below this ceiling price, at least for markets where available volume is small in relation to the additional demand.
The German example illustrates this. On current planning, Germany will not take on any new (additional) debt in 2015. This implies that this year's total Bund issuance will be only €140bn. However, the ECB is committed to buying €160bn of this paper. At the same time, German banks must increase their regulator-imposed liquidity reserves by around €20bn. And they are only allowed to use highly liquid and readily marketable paper, essentially Bunds. This suggests structural demand for Bunds of roughly €180bn in 2015, well ahead of supply.
So holders of Bunds must divest part of their holdings. The big Bund investors are banks, insurers and central banks. None of these investor groups has any incentive to sell their holdings. Both banks and insurers need these bonds and their comparatively high yields to sustain their business models and satisfy regulatory requirements.
Selling bonds from their stock would mean forfeiting future income. These holders could make good the resulting deficit only by taking on higher risks elsewhere, a development that both the insurers' customers and the banks' regulators would view unfavourably.
As a result, Bund prices across the maturity spectrum will quickly head up towards the ECB's stated maximum – without any regard to the evolution of the fundamental conditions that shape yield curves in normal times. Bund yields will probably quickly turn negative out to 10 years.
As a result, the yields of other euro countries' bonds should also fall perceptibly and their spreads to Bunds narrow even further – and once again this process will occur in isolation from the fundamental trends of individual economies.
So what are the foreseeable ancillary effects? Traditional investors will be forced out of the government bond market and into riskier asset classes. In addition, market mechanisms will be rendered largely ineffective since the market prices of bonds no longer adequately reflect their inherent risk.
This will have spillover effects on the equity markets that have to absorb part of the excess liquidity. Share valuations will be inflated to levels that have regularly proved unsustainable in the past.
Surging liquidity, more risk on the balance sheets of banks and insurers, sky-high valuations in individual asset classes – these are some of the already visible consequences of the ECB's policy, and the trend is set to continue. It feels as if the markets are programmed to crash when the ECB's QE programme nears its end, if not before.
Stefan Bielmeier, a member of the OMFIF Advisory Board, is Global Head of Research and Economics and Chief Economist at DZ BANK
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