The ECB will launch its QE programme on Monday. We believe there to be a nonnegligible likelihood that the ECB will be forced to expand its bond-purchase programme, which is one reason why Bund yields will not rise much once QE starts, in contrast with the Fed’s QE programmes. Reactions are more likely from EUR-USD and the DAX, for which we have raised our year-end forecast. We have also raised our 2015 German GDP growth forecast to 1.8%, up from 1.5%, primarily due to the depreciation of the euro. Market still expecting more The ECB Council has just finalised the legal framework for the bond purchase programme. It will thus start buying bonds next week, the aim being to spend a total of €60bn each month – €40bn on government bonds, €4bn on bonds from public agencies such as KfW, €6bn on bonds issued by EU institutions and €10bn on covered bonds and ABS. The scheme is intended to run until September 2016, but can be extended, for example if neither inflation nor market-based inflation expectations rise as the ECB hopes.
We can well imagine that in this case the ECB would increase its monthly purchase volume. It is true that government bonds, in particular from the core countries, are soon likely to become scarce because domestic banks and insurance companies as well as foreign central banks have little incentive to sell their holdings to the ECB (see cover chart). However, if it came to the crunch, the ECB could buy up more government bonds from the peripheral countries. It could also buy far more ABS, if the ECB together with the European Investment Bank (EIB) and the European Commission, was able to reinvigorate the market for asset-backed securitisations.
Little rise in expected Bund yields once ECB acts Some investors nevertheless fear that Bund yields will rise markedly once the ECB begins buying next week. Opportunistic investors are said to have bought many bonds in order to sell them to the ECB from Monday. Accordingly, without these investors’ demand of bonds carrying on, yields would rise. This is what at first glance occurred in the US when the Fed began buying bonds under its QE1 to QE3 programmes (see chart 1).
While Treasury yields dropped sharply prior to the purchases, they rose again once the programme had actually kicked in. However, the main reason for the rise in yields shortly after QE1 was launched was that the shock of the Lehman Brothers collapse at the turn of 2008/2009 gradually faded and investors moved funds out of the safe haven of government bonds. Moreover, during the third programme (QE3), US yields only rose sharply when the Fed raised the prospect of tapering in early summer 2013. Only once QE2 began did the market move on the principle of ‘Buy the rumour, sell the fact’. However, the scope of QE2 was limited from the start, which is not the case with the ECB’s programme. CHART 1: US yields only seemed to rise with QE 10-year Treasury yields, in per cent CHART 2: ECB’s QE puts pressure on swap spreads German covered bond average asset swap spread, in basis points; daily average ECB purchase volumes as part of the third covered bond purchase programme (CBPP3), in €bn
The shortage of core-country government bonds noted above is one argument against substantially higher Bund yields once ECB purchases start. A similar shortage after the start of the ECB covered bond purchase programme last September prompted a further decline in covered bond yields (see chart 2). Consequently, we envisage Bund yields being only marginally higher at the end of this year (forecast: 0.60%) only because the US economy should remain robust and the markets are probably underestimating the scale of Fed rate hikes. And this is precisely what William Dudley, the influential head of the New York Fed, warned of just recently.
Euro set to lose ground to dollar once QE begins Like the Bund yield, EUR-USD has come under pressure simply as a result of the QE announcement. Experience with US bond purchases suggests, though, that the purchases themselves will further weaken the euro: When the Fed bought up bonds and expanded its balance sheet in 2009, and again from mid-2010 to mid-2011, on a bigger scale than the ECB, the euro tended to gain against the dollar (see chart 3). Conversely, it lost ground when the ECB expanded its balance sheet more than the Fed between mid-2011 and mid-2012 as the sovereign debt crisis came to a head. This correlation only collapsed when the Fed announced in the early summer of 2013 that it would be scaling down its purchases. Theory, too, suggests that both the announcement and actual purchases of government bonds can weaken a currency, since the liquidity thus passed into circulation will be invested. If domestic yields have already dropped sharply, investors go for higher-interest foreign investments, thus boosting the respective currencies. Ten-year Treasuries, for example, now offer higher yields than Portuguese bonds. Another pointer to the euro retreating versus the dollar is that the markets will probably be expecting too little in the way of US rate increases. At our recent monthly forecast meeting, we left our year-end forecast for EUR-USD unchanged at 1.04. Further boost to DAX from ECB-induced pursuit of yields While the euro will no doubt continue to suffer from QE, the DAX should benefit when the ECB starts buying bonds. Admittedly, the main reason for DAX gains over the past two and a half years has been a rising P/E ratio, whereas corporate earnings have risen only marginally (see chart 4). However, the P/E based on expected 2015 earnings, at 14.5, is not much above the long-term average. Moreover, it is doubtful whether investors look at the P/E ratio in terms of past averages while interest rates are so low on account of the ECB’s zero rate policy. What is more likely is that, in the absence of viable alternatives, investors are not overly concerned by a higher P/E ratio, especially since the DAX dividend yield of 2.8% far exceeds yields on government and corporate bonds. At our monthly forecast meeting, we raised our year-end DAX forecast from 10,800 to 11,800, which implies a 20% gain versus the end of 2014.
