Bond markets weigh risks of eurozone QE

At last, after resisting for so long, the European Central Bank looks closer to implementing its own version of quantitative easing to spark growth across the eurozone. But will it dislocate the bond markets?

Some investors and strategists are asking this very question as they raise their expectations of QE, the once extraordinary policy that is now the standard monetary response to low growth and inflation. The US Federal Reserve, Bank of England and Bank of Japan have all resorted to QE to boost growth.

The problem for the eurozone bond markets is that QE could undo the gains since ECB president Mario Draghi triggered their recovery by pledging to do whatever it takes to prevent the collapse of the single currency in the summer of 2012.

Mr Draghi's promise has brought peripheral bond yields, which have an inverse relationship with prices, down sharply and narrowed their spreads against Germany, the benchmark market.

Steven Major, global head of fixed income research at HSBC, warns: "QE is a potential risk for the eurozone bond markets. It is a step into the unknown and could lead to spread widening among the peripheral markets against Germany."

This threat of widening spreads would reintroduce the problems seen at the height of the eurozone crisis as it would make Germany more competitive with lower borrowing costs at the expense of other economies.

Mr Major worries that this spread widening would be inevitable.

This is because the ECB would have little choice but to buy government bonds to bring about the stimulus required to lift inflation. Other bond markets, such as asset backed debt, are not big enough to enable the central bank to buy in a size that would make a difference - and buying government bonds almost certainly means purchasing more German Bunds than other debt, pushing Berlin's yields down at a faster pace.

Investors and strategists expect about 30 per cent of the bond buying will be in German Bunds in a €400bn programme. The ECB would then likely buy about 20 per cent in French OATS, 18 per cent in Italian BTPs, 12 per cent in Spanish Bonos, with the rest being bought in the other much smaller debt markets.

Laurence Mutkin, global head of G10 rates strategy at BNP Paribas, argues that the purchases will have the opposite effect. That buying a larger proportion of German bonds will actually help narrow yield spreads between Bunds and peripheral debt.

"It's not about quantum," he says. "It is about the size of the available float."

For example, the German market is much bigger and deeper than the Spanish market. This means the ECB could afford to buy a smaller amount of Spanish bonds to move yields further than in Bunds.

For others, issues over the legality of a bond buying programme is a greater concern.

The German constitutional court has asked the European Court of Justice to make a ruling on outright monetary transactions, which Mr Draghi introduced as a backstop to the eurozone in the summer of 2012.

Although outright monetary transactions would involve buying government bonds, it is not the same as QE as it would be introduced in the event of a run on one or more of the debt markets.

The ECB could successfully argue that QE, which involves buying a range of bonds to lift inflation, was within their remit as it is designed to bring about price stability.

But, the legal wrangling is still creating confusion.

One bond investor at a big German asset management group says: "I think the legal situation complicates everything. Markets don't like uncertainty. It is that simple. The lawyers don't seem to care about this. It is very frustrating."

He thinks QE is inevitable, whatever the lawyers say, possibly as early as the second quarter of this year. The ECB will have little choice but to follow other central banks and join the QE club if low inflation persists, he says.

Harvinder Sian, co-head of European rates research at RBS, agrees: "The risks are probably greater by not doing QE, than doing it - and it looks likely it will happen."

But QE is not the endgame, he adds. "QE is another stage in the road to recovery for the eurozone. But it is a policy that highlights the problems in the region. With the amount of public debt that most economies are still carrying, the eurozone crisis is far from over."


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