Despite the European Central Bank increasing its purchases of government bonds and broadening its QE programme into corporate credit, a lack of eligible assets could cause further market dislocations, argue Joubeen Hurren and Orla Garvey.

 

Whether cutting interest rates into negative territory or expanding their already massive quantitative easing (QE) programmes, few would argue against the view that central banks have gone to extraordinary lengths to stabilise economies in the post-financial crisis years.

However, the effectiveness of such measures is under increasing scrutiny, with many analysts and politicians now arguing that the costs outweigh the benefits.

In Europe, for example, the European Central Bank is currently buying up to €80 billion a month of government and corporate bonds, yet there is little sign that the policy is succeeding in its aim of boosting growth and inflation.

The programme is currently scheduled to draw to a close in March 2017. However, with economic recovery in the region remaining fragile, it is possible the ECB could extend the programme. In this Q&A, Joubeen Hurren, Credit Fund Manager, and Orla Garvey, Sovereign Fund Manager, explain the impact of the policy to date, the risks it entails and consider how it could be modified in the future.

 

Three-months into the ECB’s expanded bond-purchases programme, is it running out of bonds to buy? Which bonds in particular are affected?

Orla Garvey: Initially, the scarcity issue affected bond markets in peripheral euro-zone economies, which are less liquid, have a smaller issuance programme and a much smaller domestic investor base than, for example, Germany. That situation has eased somewhat because euro-zone members, including peripheral countries, such as Portugal and Italy, are now issuing more and extending the maturity of those bonds to improve their debt sustainability profile. Overall, the average maturity of euro-zone debt has increased to more than nine years from eight years, and has been issued at lower interest rates, helped by ECB QE buybacks.

The ECB is facing some challenges with its existing QE programmes and will encounter scarcity issues within six months, unless it adjusts the existing €80 billion per month purchase programme if it decides to extend it.

Joubeen Hurren: It could potentially increase its purchases of corporate bonds. There is an argument that investing directly in corporates will be more effective in stimulating the economy than buying government bonds, given that government bonds yields are already so low. Reducing corporate debt costs encourages companies to invest directly into the economy, while valuations in credit do not appears as stretched as they are among government bonds. Moreover, greater political will and cohesion are required in some major economies if fiscal policy is to play a greater role.

If the ECB elects to expose itself to riskier debt, will that store up bigger potential risks than many central bank members would want?

JH: There are potential unintended consequences of the ECB’s purchase of corporate bonds. This effectively prolongs the credit cycle as corporate bond spreads remain artificially compressed. The more the ECB buys, the less differentiation there is between the spreads on well and poorly-managed companies. Companies that should not be in business or that should not be able to raise finance so cheaply will survive. We can look across the Atlantic to see the problems such a situation can cause. US companies in the shale sector with very high operational costs were able to raise finance at low costs partly due to the Federal Reserve’s QE programme. More than 100 North American energy producers have now declared bankruptcy and many more shale operators are struggling to survive.

It’s a similar story in China, where credit growth has been faster than GDP growth for a number of years. This has caused a misallocation of resources as money has flowed into  zombie industries and companies.

Such a misallocation of resources can potentially have deflationary consequences. Central banks are clearly trying to drive economic growth in such a way that creates inflation and higher inflation expectations. Yet overinvestment leads to overcapacity, which increases the output gap, a development that has deflationary consequences. The ECB and other central banks are effectively distorting the market economy where companies that can compete will prosper and expand, while the inefficient are allowed to fail. There is a strong argument that current monetary policies are supporting some enterprises that would not be in business otherwise. The adverse long-term consequences of these policies are unclear.

Are there any signs that the bank’s mass purchase of bonds is having an impact on inflation and economic growth?

OG: Progress has been slow and it appears not to be working. However, it is impossible to know how economies would have fared without the central bank’s use of unconventional policies. The Bank of Japan (BoJ) has probably been the most adventurous of the world’s central banks in terms of the tools that it is employing to fight deflation. It is currently deploying a `shock-and-awe` approach involving massive rounds of monetary stimulus to generate higher inflation expectations. The latest figures show core inflation in Japan — all prices minus fresh food — falling by an annual rate of 0.5%, far below the central bank’s inflation target of two per cent. Yet we cannot know what the figure would have been without the BoJ’s policies.

In September, the BoJ switched tack, abandoning its targets for expanding the monetary base and focussing upon pushing the real yield curve lower until inflation is growing sustainably at more than two per cent, a policy that aims to support inflation expectations.

Is that why there is increasing talk of using fiscal policy rather than monetary policy to spur economic growth? 

JH: Absolutely. The marginal return of each round of QE is now diminishing rapidly. That's why the BoJ’s change of direction received so much attention and it explains why policymakers are increasingly exploring the use of fiscal policy as a means to reflate economies. The argument is that monetary policy simply inflates asset prices rather than the real economy, while also exacerbating inequality.

There is a good case for higher fiscal spending in areas such as capital investment in infrastructure, especially given that governments can raise the finance for such schemes very cheaply at the moment. Political divisions are the main obstacle to the increased use of fiscal policy. The US congress is gridlocked, while Europe appears increasingly fragmented politically. We might see higher public expenditure in the UK following the change of government but we would need to see a large wave of higher public spending globally to spur economic growth and inflation.

The ECB limits purchases to bonds with maturities of between two and 30 years and with a yield above the euro-zone’s deposit rate of minus 0.4 per cent — a restriction that has caused an increasing squeeze, as the rally in bond markets pushes the yields on euro-zone debt into negative territory. Could it change these criteria?

OG: Theoretically, the ECB could make a number of changes. It could, for example, alter the so-called capital key, the current framework that determines how much debt is bought from each euro-zone government; in other words how many Italian bonds are bought in comparison to German bonds. It may also extend the maturity restriction given that many countries have been issuing 40 and 50-year bonds recently, which has helped improve their debt sustainability profiles.

JH: The restriction in terms of the deposit rate debars a high percentage of bonds outstanding. Relaxing that rule could be easier in political terms than changing the capital key. There is speculation that the ECB might start to buy senior financial debt, but that seems unlikely. The ECB has already announced a new wave of large-scale, long term refinancing operations to provide banks with cheap funding. Moreover, companies do not lack access to cheap capital: they simply do not see major investment opportunities in Europe.

In addition, the ECB is one of the main regulators of the European banking sector. There is clearly a conflict of interest when a regulator starts to buy the debt of the institutions it is overseeing. That said, one cannot completely rule out the possibility the ECB will buy senior financial debt, if only because Mario Draghi has demonstrated that he will go to almost any lengths to restore inflation and economic growth.

Has monetary policy been deflationary in some ways?

JH: Yes. While it could be argued that charging negative rates on deposits will encourage spending, the opposite might be true. People may decide that given paltry returns and charges that are eating into their savings, they need to save even more. They are naturally cautious following the biggest financial crisis in decades. Changing demographics are also an influence. Older people, who have paid off their mortgage and other loans, may decide to increase their savings rather than make significant purchases. Central banks are also increasingly aware of the impact of very flat, long-end curves on the insurance industry and the adverse implications for pensions deficits. That is probably the main distortion central banks wish to avoid.

Some economists say the European Central Bank should start to invest in equities. Do you agree?

JH: No, because that would have the same negative effects that we have seen in the corporate bond market. There is a risk that it leads to a misallocation of capital and simply inflates asset prices rather than boosting the real economy. Moreover, there is the adverse impact on wealth distribution. People who don’t own financial assets are not benefiting from monetary policies like QE. This is creating a growing sense of alienation and is driving support for populist politicians and policies in Europe and North America, and exacerbating the political gridlock.

When it launched the programme, the ECB said that it “will be mindful of the potential impact of its purchases on market liquidity.” Has liquidity been affected?

OG: Liquidity among government bonds has improved during previous rounds of QE reflecting the fact that central banks were buying bonds. Previously during periods of risk aversion, liquidity in the corporate bond sector simply dried up and there were few buyers, partly because investment banks – the traditional liquidity providers in the market - cannot or are severely restricted in buying more bonds. Corporate bonds, for example, are generally held in very concentrated pools of funds and there isn't as much two-way flow in the market as in the past. The ECB’s presence therefore makes a real difference to liquidity in this area.

However, this is something of a double edged-sword. Markets have become reliant on central banks to inject liquidity in the system – when they eventually pull back from their asset purchase programmes, conditions will become more volatile.

Draghi has dashed hopes for an expansion of the programme of bond purchases, and offered no guidance on whether the scheme would be extended after it expires in March 2017. Do you think it will be extended?

JH: We wouldn't necessarily say he's dashed hopes for an expansion. We still believe an extension will be announced in December and it would have been surprising if it had been announced in September. That is partly because recent data has not been that bad and it also seems sensible to wait until December so that the ECB can assess as much information as possible before making a decision. 

What are the main obstacles to such an extension?

JH: There are no significant obstacles to an extension in the current framework. There could be some political issues if the ECB changed that framework significantly. 

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 18 October 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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