Stuart Steven

QE – what is it good for?

Stuart Steven

While not quite absolutely nothing, it is clear that, over recent years, the impact of quantitative easing (QE) has dwindled to the point where new programmes arguably provide little net benefit to the real economy.

Although the situation is similar for all the countries that have had large-scale QE, the European Central Bank (ECB) experience is a particularly good example to examine due to its size and breadth and the results it has delivered. This is also an opportune moment to review QE in Europe given that the ECB has just announced a new round of open-ended asset purchases, to the tune of €20 billion a month from 1 November.

To understand why QE is now a far less effective tool, it is important to remember why it was initially introduced in March 2015 and reflect on the changes in economies and markets since.

Originally, the ECB was reluctant to implement QE as it feared the sharp and sizeable increase in liquidity would lead to significant inflationary risks. Added to this, the approach was largely untested so it was impossible to predict the outcome and any unintended consequences. However, following a period in which conventional monetary easing was largely exhausted, it was clear a new strategy was needed to address several concerns in early 2015, including:

  • Bank balance sheets were too large and they needed to de-lever to comply with tighter banking regulations.
  • Capital markets were not operating efficiently: financial and non-financial companies were struggling to finance at affordable levels.
  • European economic growth remained very weak and inflation stubbornly low despite monetary easing.
  • There was a risk that member countries would seek to leave the eurozone.

By injecting liquidity into the system, the ECB successfully provided banks with the time and space they needed to increase their capital, work through their non-performing loan stock and access affordable funding. Without this, bank deleveraging would have been quick and dramatic and would have resulted in significant levels of corporate and personal failures and a far bigger negative impact on the real economy. A number of second-tier banks would also likely have failed.

QE also provided confidence to capital markets, allowing companies to fund at affordable levels through the bond market rather than rely on banks. Finally, it significantly reduced government yields to help reduce the funding burden on governments throughout Europe to alleviate the impact of high levels of government debt. The final point has been so “successful” that German 30-year bonds, until last week, traded on negative yields.

German 30-year Government bond yield

Simplistically, the ECB’s QE programme successfully unblocked the supply side of monetary policy while its aggressive policy easing helped address the problem of a lack of demand for money. But while it is obvious emergency yields and QE were both necessary and successful after the Global Financial Crisis (GFC), it is less clear what further easing and QE will achieve as today’s challenges are different.

First off, companies now have ongoing access to plentiful funding at historically low levels of yield. Government yields are negative across much of Europe, and even peripheral government yields are very low (2.0% for Italy, and 1.0% for Portugal and Spain). Corporate bond spreads are also close to post-GFC lows.

European fiveyear Investment Grade spreads basis points 

With yields and spreads at historically low levels, it is hard to believe the marginal reduction in rates will encourage companies to increase borrowing to invest, as evidenced by the fact that many are not willing to do so when they can to borrow five-year funds at zero cost. Today’s problems are neither supply related nor due to unaffordable pricing, but rather confidence related.

While the downturn in global growth over the last 12 months, largely caused by various international trade disputes, has damaged confidence, QE may also be to blame in part. Negative yields undermine confidence by sending a message of no growth or impending recession, reducing consumption because savers and pensioners who rely on low-risk investments (cash or bonds) are not receiving an income.

Governments now effectively own a significant proportion of bond markets (at low or negative yields) and this could also undermine economic growth over the long term. This is because low yields negatively impact the solvency of pension and insurance funds. Historically, low yields, coupled with a flattening of the curve, also undermine bank profitability. At least by (finally) introducing deposit tiering in its recent QE announcement, the ECB has helped to mitigate the impact of negative yields on earnings for European banks. 

While QE has done much of the heavy lifting to prop up growth within Europe, we need to be aware of its limitations and unintended consequences. It may make theoretical sense to allow countries and companies to borrow at zero or below, but it makes no sense for investors to buy these bonds. To do so, investors are being asked not only to lock into a ludicrously low return but more dramatically a likely negative real return of between -2% and -3%. Moreover, it is also worth bearing in that mind that bonds will potentially suffer large capital losses when central banks eventually succeed in their efforts to boost the economy and inflation.

By way of an example, investors that own the newly issued German 30-year government bond will suffer a mark-to-market loss of over 25% in the event that its yield increases to a mere 1.00% from its current -0.02%. Perhaps investors are starting to wake up to these realities: when this new issue came to market last month, there was only EUR800m of real demand, compared to the government’s target issue size of more than EUR2bn.    

The ECB has done all (and more) that could reasonably be expected to support the economy and, as such, it is now the turn of governments to help through fiscal measures. Governments “owe” the ECB this much, particularly as all EU countries have benefited from the abnormally low yields they have been able to borrow at over recent years.  


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Monday, September 16, 2019, 10:59 AM