Mario to Athens

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Mario Draghi

The ECB delivered a much larger than expected QE programme, which is pushing down government bond yields and the euro and supporting risky asset prices. We think QE will lift growth and inflation, but Europe’s long term economic performance depends crucially on reform. European data this week were encouraging, suggesting a moderate recovery was already taking shape pre-QE. All eyes now turn to Greece, which seems set for a Syriza-led government. We think that Greece will eventually reach an agreement with other eurozone member states and the troika, even though it might be a bumpy ride in the meantime.

We expect the QE programme to lift growth and inflation and it is therefore well worth doing. Nick Kounis Nick Kounis Head of Macro Research

ECB turns to bazookanomics

The ECB surprised with a much bigger asset purchase programme than expected. It added government bonds and agency debt to its existing programmes and in total will now buy EUR 60bn a month ‘at least’ through to September 2016. This points to a programme totaling EUR 1.14 trillion.

However, ECB President Draghi went further, saying the plan was open-ended and would continue up until inflation had embarked on a path towards its inflation goal over the medium term. So the programme could exceed 1.14 trillion if necessary, though there was an upper limit per issuer. The ECB also plans to buy long maturities (up to 30-years).

Decomposing the programme

Of the EUR 1.14trn, we think that the existing covered bond and ABS programmes will account for EUR 150bn. That leaves around EUR 990bn of new money. Of that, around EUR 120bn will be made up of European-level agencies, while the remaining EUR 870 bn will be accounted for by government bonds and national agencies. The total will be shared between countries using the capital key, which means that countries with a relatively low outstanding stock of securities compared to their GDP benefit the most directly (see table).

The programme will focus on investment grade bonds, but the ECB opened the door for Greek government bond purchases as well. The country would need to be on track with an adjustment programme and the ECB’s existing holdings of Greek bonds would need to fall below 33% of the total (will happen in July).

Risk sharing limited, but issue played down

The degree of risk sharing is relatively limited, at 20%. However, Mr. Draghi played down the issue, saying that it was not that important. He said that in the ‘theoretical’ case of a default, central banks had sufficient buffers. This is debatable, but it seems the ECB President sees this concession to the hawks as just ‘window dressing’.

In a separate decision, the ECB also reduced the interest rate on its upcoming TLTRO operations by 10bp, taking it to the same level as the refi rate. This could increase bank take up at the margin.

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Positive for growth and inflation…

We expect the QE programme to lift growth and inflation and it is therefore well worth doing. The main effects will come through a lower euro and easier financial conditions more generally, especially in the periphery. The ECB is missing its inflation goal and therefore it had a duty to act and it is not as if it had a tool box brimming with alternative options.

…but not a miracle cure

We should not expect miracles. There is little doubt that weak demand is an issue in the eurozone and we think QE will help. However, arguably the bigger problem is that the eurozone’s trend or potential economic growth rate has declined. To lift economic performance over the long-term, governments need to step up structural reforms.

Markets rally on announcement, with risky assets leading the way, while euro slumps

European government bond yields fell sharply following the announcement, led by the periphery, while equity prices surged. In addition, the euro fell significantly. It is typical that risky assets do well and the currency slumps on the back of QE. This is exactly the experience we saw during the various phases of QE in the US. Indeed, we expect risk premium compression and euro weakness to continue going forward.

High quality bonds also supported on demand-supply imbalance

What is less normal is that safe government bonds (for instance Germany and the Netherlands) have also continued to rally, with yields falling to new historical lows. In the US yields rose sharply following the QE announcement, as investors expected an economic recovery and as money flowed to higher yielding assets. The stark difference in behaviour of core yields in the eurozone likely reflects that these markets are shrinking. Therefore ECB purchases could lead to an acute demand-supply imbalance. This means that there are now significant downside risks to our forecast of modestly rising core yields later this year.

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Europe’s moderate recovery pre-QE

Meanwhile, we had a set of encouraging eurozone data. The ECB’s latest Bank Lending Survey painted a positive picture. It signalled a eurozone economic recovery going forward. Banks eased lending conditions at a faster pace, while demand for loans continued to improve across loan categories. The improvement in corporate loan demand – driven by rising investment intentions – was particularly encouraging. Stronger loan demand is consistent with firming economic growth in coming quarters (see chart above).

Eurozone surveys improved in December

Meanwhile, Germany’s ZEW economic sentiment indicator jumped from 34.9 in December 2014 to 48.4 in January 2015, reaching its highest level since February 2014 and rising further above its long-term average value of around 24. Furthermore, the eurozone composite PMI rose to 52.2 from 51.4 in December, the highest level since August of last year. The fall in the euro (on QE expectations) and lower oil prices appear to be having a positive effect.

China’s gradual slowdown

Outside of the eurozone, the main economic data came out of China. China’s GDP rose by 7.3% in Q4, the same rate as in Q3. This left annual growth at 7.4% in 2014, almost exactly in line with the government’s target of 7.5%. The monthly data for retail sales and industrial production showed growth edging up in December. The overall trend looks to be one of ongoing gradual slowdown and we expect the authorities to ease policy further to ensure this remains the case. The authorities will likely set the target for 2015 growth at 7%.

Greek election has raised worries of euro exit

With the ECB behind us, another big event in the calendar looms, with the Greek elections on Sunday. The polls suggest that Syriza will be the largest party. It may not get an overall majority, but it should be able to form a coalition government with the smaller Potami party. This prospect has caused some concern (though at time of writing there was no visible effect on markets glowing on the ECB euphoria). The worry is that a Syriza government would unilaterally default on its debt and refuse to stick to any of its obligations, which would lead to an eventual Greek euro exit.

Greece likely to remain in the eurozone

Nevertheless, we think it is likely that Greece will remain in the eurozone. Syriza has already significantly toned down its stance on many issues, and will likely be more constructive in government than its rhetoric suggests. Opinion polls report that the vast majority of Greeks want to stay in the euro. In addition, Greece has made a lot of progress with reforms, fiscal consolidation and wage adjustment. It would be odd to throw it all away now. Meanwhile, other eurozone countries also have an interest in keeping the club together. Although risks are lower than a few years ago, there may still be a major fall-out from a country leaving.

Greece’s unsustainable debt

A key Syriza aim if it does come into government is to get debt relief. The German government says Greece must meet its obligations. However, there cannot be anyone in the German government or elsewhere that judges that Greece’s debt burden is sustainable. Greece will very likely not be able to meet its obligations. Sooner or later it will need debt relief.

A deal is possible

Most of Greece’s debt (around 80%) is to the official sector, with the largest share (around 60% of total debt) to Eurozone member states either via bilateral loans or via the EFSF. So a debt write-off would need to involve other member states. An outright debt write off will obviously be politically difficult as it will be unpopular in other eurozone states. However, significant debt relief could be provided by further lengthening maturities and freezing interest payments. Indeed, the Eurogroup already committed to do this in a statement on Greece in November 2012.

Debt relief could be made conditional on actions by the Greek government. While Syriza is less willing than the previous New Democracy–led governing coalition to cut welfare spending, it will be more willing to fight tax evasion and go after vested interests. In any case, there looks to be sufficient room for negotiation.

Uncertainty will not go away

Although we expect a solution, this does not mean it will be smooth. Negotiations might be tough and there may be a lot of pre-positioning by the different actors in public. Tough talk could lead to nervousness. So we may well be in for a period of uncertainty as far as Greece is concerned. Still, we do not expect any significant contagion.

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