Quantitative easing with the ECB was never going to be easy. Don’t forget, this is the central bank that seems to have given us more new acronyms during this crisis than all other central banks combined (SMP, TLTRO, OMT to name a few). Today’s announcement has proven that, with the principal complication being the extent of risk sharing between the Eurosystem (i.e. collectively by national central banks combined) and national central banks unilaterally.
There are two key points here. Firstly, the net result is that 20% of the additional asset purchases will be subject to “a regime of risk sharing”. The remainder will not be subject to this. So, the ECB states that in the situation of ‘hypothetical losses’, these would be borne by the respective national central banks. This applies both to default, but also with regards to any future (potential) losses. But it was only in the Q&A that the ECB confirmed that these central banks purchases would be pari-passu (i.e. on the same level) and privately held debt. There were some fears that they could be senior to it, so this is one reason why the reaction of the euro has been more dramatic than most were expecting. We are not going to get a two-tier bond market where the risk was going to increase on the privately held proportion.
The interesting reaction has been in the bond market. We’ve seen yields higher in the core markets, so France and Germany, with yields falling in the periphery, such as Italy and Spain. The latter naturally have further to fall, so the bang for the buck is going to be greater. The ECB’s actions have to be welcomed given the current deflationary threat that the Eurozone faces. That said, there are three main areas of concern.
The first is that this is happening very late, at a time when yields have already fallen substantially (some in anticipation of the move). The Eurozone has already received a decent amount of tail-wind from QE programs elsewhere. Remember that QE is designed to see money flow into other assets beyond bonds, be they domestic or overseas. Secondly and following on from this is the degree to which the ECB is contributing to a mis-pricing of risk within the bond market. Don’t forget that such a mis-pricing of sovereign risk within the Eurozone was a key feature of the pre-credit crisis environment. Whilst premium are wider (Italy just over 1% above Germany, vs. 0.2%-0.3% in 2007), yields are lower. Finally, the compromise on risk sharing (which we must presume it was) reflects that the ECB has succumbed to the politics of a sub-par monetary union (i.e. Germany)
In summary, this is only the start. We are not going to see the text-book response sustained (i.e. lower yields, weaker currency) owing to the underlying complications of QE in a monetary union. We’re going in the right direction, but on a very bumpy road where accidents are more likely to happen.