The Unbearable Lightness of ECBeing

European Central Bank (ECB) President Mario Draghi is feeling positively chipper about the eurozone economy. GDP has grown for 15 consecutive quarters and inflation is nearing the ECB’s just-under-2% target. Mandate accomplished! Many people now anticipate an end to the ECB’s “non-standard monetary policy measures”—quantitative easing (QE) to most—and, perhaps after that, hiking rates back above zero. This has some observers speculating about the impact of tapering QE and worrying it will hurt continental equities. But extant evidence suggests these fears are overdone. Tapering QE is much more likely to help eurozone equities than hurt.

QE is commonly misperceived as stimulus—including by the ECB—but in practice it hinders economic growth. When the ECB buys long-term bonds in large quantities—so much so they’ve struggled to find enough—it raises their prices. Since bond yields move inversely to prices, rising prices mean falling yields. Central bankers think lower long-term rates stimulate growth by making borrowing cheaper for individuals and businesses, driving loan growth. The problem is, this ignores the supply side. By reducing long-term interest rates while short rates are fixed, QE also narrows the spread between the two—flattening the yield curve. Because banks’ lending profit margins depend on this spread—they borrow short, lend long and pocket the difference—flattening the yield curve lowers their incentive to lend, stifling businesses’ credit access and dragging on economic activity.

QE didn’t create the eurozone’s economic expansion. QE began in early 2015,^[i] but eurozone GDP had already been growing for two years by that time. (Exhibit 1) The economy surpassed its Q1 2008 peak—officially progressing from recovery to expansion—one quarter later. Before the ECB’s “expanded asset purchase program” (EAPP) was announced in January 2015, the eurozone’s 2011 – 2012 sovereign debt crisis was over. ECB emergency lending undertaken during that time was no longer needed. As credit markets normalised, the ECB’s balance sheet shrank.

Exhibit 1: Massive ECB Balance Sheet Expansion Hasn’t Done Much

Source: Federal Reserve Bank of St. Louis, as of 28/4/2017. Seasonally-adjusted quarterly eurozone GDP at constant (2010) prices, Q1 2007 – Q1 2017. European Central Bank assets, January 2007 – April 2017. Presented in terms of US dollars. Currency fluctuations between the dollar and the pound sterling may result in higher or lower investment returns.

We can’t know how much faster eurozone growth would have been sans QE, but after the ECB announced a QE reduction last December, eurozone yield curves steepened, lending picked up, and Purchasing Managers’ Indices suggest growth accelerated. Coincidentally, eurozone equities are leading the developed world for the year to date. Similar growth boosts occurred in the UK and US after the Bank of England ended QE in November 2012 and the Federal Reserve announced its QE taper in December 2013. The evidence overwhelmingly suggests QE has been counterproductive and ending it is positive for the economy and markets.

Ongoing eurozone economic improvement belies the need for “monetary accommodation”^[ii] and argues for further reductions in ECB asset purchases—tapering—to a full stop. If Draghi’s latest commentary means that’s in the cards, great, but it’s impossible to predict based on his or any central banker’s coaxing. That said, if it takes a while to officially taper, fine! Markets discount widely discussed expectations. US taper talk sent long rates higher months before Bernanke finally tapered, and equities rallied throughout. (Exhibit 2) We’ve seen that to an extent in Europe as well. Taper talk has its own brand of bullishness.

Exhibit 2: Equities Love Tapers!

Source: Federal Reserve Bank of St. Louis, as of 28/4/2017. S&P 500 price level, 3/1/2012 – 27/4/2017. Presented in terms of US dollars. Currency fluctuations between the dollar and the pound sterling may result in higher or lower investment returns.

As for interest rate lift-off, the sooner the better, too. Negative interest rates are essentially a tax on banks, cutting their profitability. Removing them would take away another impediment to lending and likely boost economic growth further, not to mention eurozone financials’ earnings. A brighter economic outlook—and a more upbeat Draghi—hopefully brings forward the day when counterproductive ECB monetary policy ends. That’s bullish for the eurozone. Regardless, a growing—and underappreciated—economy leaves equities plenty of fuel to rally.