October 20, 2014, 11:53 AM ET
ECB Purchases Begin and Markets Shrug
By Alen Mattich
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Agence France-Presse/Getty Images
The European Central Bank launched its private sector asset purchase program on Monday.
But will it work?
Everyone knew it was coming, but the timing still came as a surprise when news filtered through the ECB had started to buy French covered bonds as part of its promised monetary stimulus program.
Covered bonds — bank bonds backed by the interest flow from pools of safe loans like mortgages — from other member states are to follow, as are purchases of asset-backed securities due to start later in the year.
Because the ECB’s purchases are focused on private sector assets, rather than sovereign debt, some are calling them private quantitative easing, or QE.
In theory, they ought to work as well, maybe even better, than the more conventional type of government bond purchase-based QE that the U.S. Federal Reserve and Bank of England focused on.
Yet news of the ECB’s asset buying was met with near total indifference by investors. Instead, equities and sovereign debt fell back into the downward rut of recent weeks following a brief respite on Friday. Equities sold off. German bonds were bid higher, while those of peripheral eurozone economies fell back, leading to a widening yield differential between the core and the rest.
The message from the markets was that investors are worried that the eurozone is heading towards recession, deflation and, possibly, another round of its existential crisis.
Meanwhile, the ECB is assessing banking sector assets, the results of which are due to be announced on Oct. 26. There are worries about how much additional capital banks might be forced to raise–with central estimates of £50 billion or so for the single currency region. The greater the banks’ capital shortfall, the more constrained eurozone credit supply is likely to be, undermining the ECB’s liquidity measures, which are supposed to get banks lending.
Ordinary QE is said to work by pushing down government bond yields, thus lowering interest costs across the economy while at the same time boosting asset prices (rising prices are the flip side of falling yields), designed to encourage people to spend, borrow and thus boost aggregate demand.
The ECB’s measures should be more effective because they represent a more direct channel to credit creation. Some 80% of eurozone credit comes from banks. By buying assets directly from the market, the ECB encourages banks to create more of them, in other words to lend.
So why might it not work?
Some worry that there just aren’t enough private sector assets of the type the ECB is willing to buy to make a substantial difference to overall liquidity in the system and that because of insufficient demand and bank caution, not enough is likely to be created either.
It could be that the markets already fully anticipated the impact of the ECB’s purchase program, which might explain the indifference to the actual measures. But the widening of yield differentials suggests there’s a deeper investor uneasiness.
Of course, there’s one further mechanism by which QE seems to work: sentiment. The promise that a central bank will make every effort to pump liquidity into an economy and will keep going until growth takes off.
Mario Draghi (pictured), the ECB president promised to “do whatever it takes” to preserve the euro in what was probably the paramount example of a central bank using sentiment to achieve end results. Except now investors feel that the ECB is constrained by politics in quite how much QE it might be able to provide. And thus that it won’t be effective.
Should investors start to believe the ECB is like the emperor with no clothes, the recent unsettling market moves could become very ugly indeed.
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