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David HilleryAfter all the opposition in Europe to Quantitative Easing (‘QE’) during the worst of the debt crisis, Mario Draghi and the ECB are about to undertake their own QE programme. Sceptics argue that it is too little too late, but at least the taboo has finally been broken to expanding the monetary base in Europe.
Whatever the outcome, it is clearly a seismic shift in policy compared to the approach adopted under Jean Claude Trichet. One has to wonder if the ECB had bolder leadership at that time, would Europe still be in the predicament it is in today?
The bad news is that the change of direction is due to the spectre of deflation that is looming large over the continent. Perhaps most worrying is that the weakness is no longer isolated to the periphery nations, as the two pillar economies of Germany and France both saw their economies contract in the second quarter. In previous issues of MarketWatch, we have written about the similarities of the policy response, or lack thereof, in Europe to what happened in Japan after the 1980s, and over recent months these fears have started to become a reality.
For all the fanfare, details of the programme are still lacking. Questions still need to be answered about what exactly the ECB will buy, and whether it will do so in sufficient size to make an impact. Asset manager BlackRock has been hired to advise on the design and implementation of the programme. At this stage, it is thought the ECB will buy asset-backed securities and covered bonds in the private market.
The purchases will predominantly be from banks’ balance sheets, with the goal of exchanging assets for cash in the hope that banks will lend to the broader economy. However, QE is no silver bullet and won’t solve all of Europe’s ailments. Indeed, Draghi himself made this point crystal clear in his recent Jackson Hole speech, remarking that ‘no amount of fiscal or monetary accommodation, however, can compensate for the necessary structural reforms in the euro area’. In the case of the Federal Reserve’s (‘Fed’) and Bank of England’s (‘BoE’) QE programmes, it took roughly 3-4 years for the liquidity to work its way into the broader economy.
That said, the most immediate impact of QE is that it has helped devalue the euro. Although a weaker euro has taken longer to transpire than we expected, particularly considering the strength of US data and the weakness in European activity, it certainly makes sense from both an economic and interest rate parity perspective.
Since June, the euro has dropped 10% against the dollar, falling from 1.39 to 1.24 today. This is good news for the Eurozone economy, as in the absence of radical structural reform which politicians seem reluctant to make, a weaker euro appears the best hope to improve competitiveness and re-ignite the European economy.
The question now is how weak could the Euro get? This will ultimately depend on two factors: the scale of the ECB QE programme, and how aggressive other central banks are in raising interest rates. On the latter point, Fed Chair Janet Yellen and BoE Governor Mark Carney have signalled any tightening they undertake will be very gradual, which may limit how far the euro falls.
Also if QE does work, and the euro continues to weaken, this would lead to import price inflation. If such a scenario transpires, there will be less need for the ECB to undertake QE for a long period of time.
All things considered, the euro should continue to weaken, and we think the important technical level of 1.20 against the dollar will be tested early in the New Year. In fact, twice in the last four years, the euro has tested this level. After that however, investors may be better off waiting to hear further details of the size of the QE programme before factoring in how far further the euro will drop below this level. If the ECB deliver on a sufficiently large enough sovereign bond buying program of say more than €1 trillion, the Euro could be as low as 1.15 by the middle of 2015.
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