ECB QE – No Green Light For Interest Rate Risk by Zach Pandl, ColumbiaManagement

  • Fed officials should be encouraged by the ECB’s announcement to begin a large-scale bond buying program in an effort to shore up growth and prevent deflation.
  • The action reduces downside risks to global growth, and thus the risks of spillovers to the domestic economy. We therefore expect very few changes in this week’s statement from the FOMC.
  • Unless the global economy deteriorates meaningfully, the Fed looks to begin raising rates around the middle of this year. And thanks to the ECB, the odds of sustainable global growth are now a bit better.

Last week the European Central Bank (ECB) announced plans to begin a large-scale bond buying program in an effort to shore up growth and prevent deflation. The ECB has dabbled with limited asset purchases in the past, but this will be its first foray into conventional quantitative easing (QE) using government bonds. Six years after the financial crisis, all of the G4 central banks have now deployed this monetary policy tool. Better late than never.

This ECB’s announcement was little surprise to markets following repeated leaks in the European press over the last couple of weeks. The size of the program impressed us, however. The ECB committed to purchasing €60 billion per month of eurozone bonds (a combination of government bonds, debt issued by European agencies and asset-backed securities), and said the purchases will begin in March and are “intended” to continue through September 2016. Thus, the bond-buying plan is expected to total around €1 trillion, and could expand beyond that if the inflation outlook fails to improve.

The immediate implications for interest rates are ambiguous. On the one hand, the ECB will be buying bonds which, all else equal, will tend to push up bond prices and depress yields. On the other hand, the whole point of the program is to boost inflation, which would result in higher interest rates over time. In the Fed’s experiments with QE the latter consideration became more important after the purchase programs began (Exhibit 1).  While there’s no guarantee that the eurozone will repeat the U.S. experience, we would caution against following the ECB’s lead into high-quality government bonds at this point. Ironically, if QE works as intended, returns for government bonds will suffer.

Exhibit 1: Average change in 10-year Treasury yield around Fed’s QE announcements

ECB QE Interest rate risk

The evolving reaction in European government bond markets looks likely to drive U.S. interest rates for the time being. Long-term yields across developed- and some emerging-market economies have moved tightly together over the last 12 months. Our favorite way to show this is in Exhibit 2, which compares long-run nominal growth expectations (along the x-axis) with forward nominal interest rates (along the y-axis) for the G10 economies (each dot represents an economy; USA, Australia, etc.). Despite wildly different macroeconomic trends across regions, forward interest rates have moved in lockstep. In particular, forward interest rates have moved down in a nearly parallel fashion across all of these markets. This is a strong hint that any meaningful move higher in long-term U.S. Treasury yields is likely to occur only in a broader global sell-off.

Exhibit 2: Parallel shift down in forward rates across all developed markets

ECB QE Interest rate risk

We expect that Fed officials will be encouraged by the ECB’s announcement. The action reduces downside risks to global growth, and thus the risks of spillovers to the domestic economy. We therefore expect very few changes in this week’s statement from the FOMC. The committee can again state that it will be “patient” in deciding when to normalizing policy. This would rule out rate hikes before June—based on Janet Yellen’s clarification that “patient” means no hikes for at least two meetings. All other aspects of policy and the description of current economic conditions are likely to remain unchanged. Unless the global economy deteriorates meaningfully, the Fed looks on pace to begin raising rates around the middle of this year. And thanks to the ECB, the odds of sustainable global growth are now a bit better.