If the European Central Bank launched “quantitative easing” and bought government bonds, would benchmark eurozone yields rise or fall?
A QE programme is unlikely to be announced at Thursday’s ECB council meeting in Frankfurt, but market expectations are high of action early in 2015.
What happens to yields, which move inversely with prices, matters a lot. They could determine whether eurozone QE is perceived as a success or failure. Moreover, government bonds are used to price assets across financial markets; unexpected moves might create considerable volatility.
But the question is not easy to answer. QE by the ECB would follow similar programmes by the US Federal Reserve, Bank of England and Bank of Japan. Yet the past offers conflicting evidence about the market implications of QE. A case can be made for yields both rising and falling.
Simple economics suggests a central bank purchasing programme should drive bond prices higher – and therefore yields lower. Indeed, that is already happening. As happened previously in the US, rising expectations of a QE programme have sent eurozone bond yields down sharply. German 10-year Bund yields have this week fallen to historic lows below 0.7 per cent.
But what happens when QE is actually launched? The experience of the three rounds of US QE since 2008 shows that bond yields may rise.
One explanation is that investors “buy the rumour and sell the fact”. Shrewd investors bought US government bonds – and drove yields lower – in anticipation of the Fed stepping in as a buyer, and then got out when it did. In other words, the biggest effects of a QE programme come ahead of its actual announcement.
“Markets are forward looking – that’s natural,” says Nikolaos Panigirtzoglou, strategist at JPMorgan. “If you are speculating on an event and it happens, you take profits – so markets move in the opposite direction to what might be expected.”
Others question, however, whether that is a satisfactory explanation. More likely, says Laurence Mutkin, head of global rates strategy at BNP Paribas, US yields rose once QE was under way because investors assumed QE would lead to stronger economic growth and inflation – factors which usually drive bond yields higher.
“The only sensible thing to do when the central banks start printing money is to sell bonds. The fact that they are buying bonds doesn’t matter,” Mr Mutkin says. “During each of the three rounds of Fed QE, rates rose – and then fell when they stopped.”
Even if there was agreement on why QE can push yields higher, however, the US experience may not be relevant for the eurozone. Lessons from Japan suggest yields could head in the opposite direction.
When Haruhiko Kuroda, BoJ governor, launched his aggressive QE programme in April 2013, yields on Japanese government bonds jumped at first, swung wildly but then started to fall steadily. Even though the BoJ announced at the end of October that it was expanding the programme, they have since dropped even further. Despite a credit rating downgrade this week, yields on 10-year Japanese government bonds are barely higher than 0.4 per cent.
Why the difference with the US? Japanese yields may have fallen because the BoJ has failed to convince investors it will succeed in dragging Japan out of its deflationary mindset. Another explanation is that the scale of BoJ buying has been large relative to the size of the market – so the effect in suppressing yields is much greater.
“Many people have tried to ‘short’ Japanese government bonds and been absolutely slaughtered,” says Daniel James, global head of rates and multi-strategy fixed income at Aviva Investors. “When you have the BoJ buying on such a scale, you can’t stand in front of it.” BoJ holdings will next year account for almost 40 per cent of the Japanese government bond market, according to calculations by BNP Paribas.
By contrast, even if it bought €500bn of government debt next year, the ECB would have acquired just 8 per cent of the eurozone market.
Still, that does not mean eurozone QE would instead work as in the US in driving yields higher. One difference is that eurozone banks may be reluctant to sell government bonds to the ECB. If they park the proceeds in the ECB’s overnight deposit facility, they will incur negative interest rates imposed by the eurozone monetary guardian. If as a result the ECB has to bid more aggressively to acquire bonds, prices would rise – and yields fall.
Moreover, having waited so long before embarking on government bond purchases, the ECB may struggle to persuade investors that eurozone inflation will rise. “It has allowed a deflation – or at least disinflationary – psychology to become more entrenched,” warns Mr Mutkin.
If investors decided eurozone QE will not work, yields would logically fall. So the direction yields head will show just how markets judge the effectiveness of the ECB.
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