As ECB Agonizes over QE, Markets Are Already Half Way There

The European Central Bank has talked up the chances of launching a bond-buying program to ward off deflation and having led markets down that path there could be a serious adverse reaction if it does not follow through.

ECB President Mario Draghi pledged on Aug. 7 to use all necessary means to avoid deflation, including "quantitative easing" if necessary. He upped the ante at a U.S. Federal Reserve symposium in Jackson Hole on Aug. 22 by insisting "all the available instruments" would be used to preserve stability.

Markets needed no more invitation to start pricing in QE, no matter how difficult it remains for other ECB policymakers to swallow.

Long-term borrowing rates for eurozone governments from Germany to the "periphery" in Spain tumbled to new record lows and the euro currency shed almost 2 percent against the dollar.

Ten-year German bond yields shed 26 basis points in August, or about one-quarter percentage point, the biggest monthly fall since January, and 30-year yields lost 31 basis points, the biggest loss since May 2012. Equivalent Spanish yields dropped half a percentage point.

If the ECB does not meet market expectations, government bond yields could spike in countries like Italy, which is already back in recession, and fellow high-debtor Spain.

Deutsche Bank estimates bond investors have now factored in a 50-70 percent probability of some "QE-infinity type" program from the ECB.

A Reuters poll last week showed market economists saw a 75 percent chance of a QE program involving the purchases of asset-backed securities by March next year, and a 40 percent chance of a sovereign bond-buying scheme.

"If the economy stays at it is and the ECB does nothing, there would be some problems on the sovereign front, especially the periphery," said Luca Jellinek, head of rates strategy at Credit Agricole in London.

Analysis of other money-printing bouts around the world over the past six years shows the success of QE in reviving the real economy pivots on the bond markets cutting credit costs and that tends to happen before money printing formally gets underway.

This was certainly true of action from the Fed, Bank of England and Bank of Japan as investors move to price in the stimulus as soon as it was mooted by policymakers.

The Fed's first two rounds of QE led to "significantly lower nominal interest rates on Treasuries", according to a Fed paper from February 2011. Annual U.S. inflation rebounded from a multi-decade low of 0.6 percent in 2010 to 2 percent now.

Bank of England studies estimate that its 200 billion pounds of government bond purchases between March 2009 and February 2010 added 0.75-1.5 percentage points to the inflation rate and increased real gross domestic product by 1.5-2.0 percent.

Although Japan's battle against deflation has been longer and tougher, the BOJ's renewed QE drive since 2012 has coincided with a long-awaited rise in inflation.

NO ROOM LEFT?

One of Draghi's problem, however, is that bond yields are already at historic lows so there is little room for them to fall further.

This is a central argument behind German and other policymakers resisting any move to create money.

German finance minister Wolfgang Schaeuble said last week: "I don't think ECB monetary policy has the instruments to fight deflation, to be quite frank."

Some investors concur.

"Adding liquidity when risk and liquidity premiums are high is an effective strategy, but it is not an effective strategy when they are low," says U.S. hedge fund Bridgewater Associates.

The ECB is unlikely to move further before its last gambit - a new round of cheap long-term money for banks which it hopes will be loaned into the real economy - has even taken effect.

But with inflation perilously close to turning into deflation, the lessons of Japan's lost decade loom large as do comparisons with Tokyo's stepped up fight against its decade-long deflation via aggressive monetary and fiscal stimulus.

Markets are now pricing in something similar in the eurozone.

Ten-year German borrowing costs fell to a record low 0.86 percent last week, not even 40 basis points above the Japanese equivalent of around 0.49 percent.

Taking into account inflation expectations and liquidity and credit risk premia, analysts at RBC Capital Markets found that "real" German and Japanese yields were even more closely aligned at -0.64 percent and -0.74 percent, respectively.

"In real terms, Bunds are already very close to JGB levels, implying an as aggressive monetary stance in the euro area as in Japan," they wrote in a note to clients.

But the question of whether the ECB will mimic the Bank of Japan remains very much open.

In April, German newspaper Frankfurter Allgemeine Zeitung reported that ECB models showed 1 trillion euros of asset purchases spread over a year would boost inflation by anything from just 0.2 percentage points to 0.8 percentage points.

Back then, German 10-year yields were around 1.6 percent compared with 0.9 percent now, and Spanish yields were above 3 percent compared with barely above 2 percent now. So the impact could be even more limited.

Draghi's admission in Jackson Hole that monetary alone can't revive the economy and that fiscal policy could play a greater role pointed to the limits of the ECB's power.