Quantitative easing returns to the European Central Bank

History seems set to repeat itself in Europe. Less than a year after the European Central Bank (ECB) wound up its bond-buying program, the words ”quantitative easing” (QE) are back.

ECB President Mario Draghi sent the latest signal about the Bank’s intentions at last month’s Sintra conference for central bankers in Portugal. He made it clear additional stimulus would be required if economic conditions don’t improve.

It is good that the ECB is being proactive. History will probably judge that it (once again) tightened policy too quickly in ending its QE program last year.

But it puts fundamental-driven investors in a bind. The ultra-low interest rates and QE of the crisis era – which we’ll call ”QE1” – had an utterly distorting effect on financial markets. Valuations are meaningless if there is a buyer with bottomless pockets snapping-up everything in sight.

”QE2”is likely to have a comparable impact, so there are opportunities to capture that anticipated rally. Anticipation is already being factored into asset pricing: the yield on French 10-year sovereign bonds dipped into negative territory shortly after Draghi’s speech.

Based on what happened during QE1, other opportunities exist. The sheer volume of bonds the ECB bought pushed buyers to look elsewhere, and we can expect that to happen again. Markets will be quick to price in the generic lift that QE2 will give these asset classes, though. After all, the first round of QE has only just finished, so its lessons are hardly distant memories. The interests of investors are better served looking through to the second-order impacts and what genuine impact QE2 might have.

There is concern that valuations are going to become skewed. Companies that would otherwise have faded away because they are not competitive will be given a lifeline.

One of the most grateful recipients of the assistance will be Europe’s banks. There is value to be had in pockets of the sector from a credit perspective, but at an aggregate level, it desperately needs consolidation. More, easy monetary policy will only make that more unlikely.

The initial euphoria of QE2 also ignores the fact it will probably not be as effective as the first round. The room to cut rates aggressively just is not there.

The initial euphoria of QE2 also ignores the fact it will probably not be as effective as the first round. The room to cut rates aggressively just is not there.

QE1 might have been essential in preventing the collapse of the Eurozone, but it did not create changes in the economy that meant growth was sustainable over the long term. More bond buying will not create better outcomes for the European economy in the long run.

So while the journey to QE2 may be a good one in terms of sentiment, it could lead us to a destination that we do not want to be in. We could find ourselves close to recession, with inflation still disappointing and an ECB that really is out of firepower.

A version of this article was originally published by Investment Week on 1 July 2019.


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