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Asset allocation: What would be the impact of large-scale European QE?

The essential

The beginning of 2015 holds the prospect of a new quantitative easing programme from the European Central Bank. The 50% increase in the ECB’s balance sheet announced by Mario Draghi will certainly have major consequences, including confirmation that short rates will be kept at zero and that long rates will decline further.

And if the markets are receptive, it will also mean renewed equity growth and changes to government and corporate bond spreads. The depreciation of the euro will be another desirable effect of QE. In order to increase its balance sheet by €1 trillion, the ECB will need much more than TLTROs and purchases of ABS and covered bonds. Now there are expectations of a corporate bond purchasing programme or a government bond purchasing programme, or both. The risk is that the ECB will disappoint.









For nearly three years, the European Central Bank has engaged in unconventional monetary policy programmes. There are multiple reasons for this:

  • First, the slow pace of economic growth following a major recession and the emergence of unprecedented economic divergences between eurozone member countries. Many of these divergences continue and some convergences are fallacious, such as current account surpluses, which essentially reflect excess savings in Northern Europe and investment deficits in the south—two diametrically opposed realities with very different consequences;
  • Second, the will to reinforce the European banking system, significantly impacted by excess credit, declining results and financial fragility in general;
  • Extremely low interest rates were also part of its strategy to stimulate investment and, above all, to improve the solvency of entities that were insolvent or whose solvency had deteriorated.
  • The ECB also became aware of the need to encourage access to credit, particularly for small and medium-sized companies which play a critical role in European economies in terms of both employment and investment (see our December issue for more on this point).
  • Finally, there is the need to pull out of the deflationary spiral hampering economic growth. The decrease in inflation leads to the postponement of consumption, investment and hiring plans, which considerably reduces the growth outlook.

ECB President Mario Draghi very recently reaffirmed the extent to which he is committed to further increasing the size of the ECB’s balance sheet. The €3 trillion target (an increase of €1 trillion, equivalent to 10% of the eurozone’s GDP) was confirmed as economic growth forecasts were revised downward: the ECB now foresees GDP growth of 1% in 2015 (versus 1.6% beforehand) and 1.5% in 2016 (versus 1.9% beforehand). He also reiterated that the ECB was ready to alter the “size, pace and composition of its measures” beginning in early 2015 if growth and inflation indicators deteriorate further. Even more recently, the ECB’s chief economist Peter Praet indicated that the eurozone’s inflation rate may dip—temporarily—into negative territory. When we consider that little more than two years ago only 5% of the eurozone was in deflation, we better understand the ECB governing council member’s statements. Apart from LTROs as well as ABS and covered bond purchasing programmes (which together will represent €500-€600 billion at most), it is now a question of whether QE will involve government or private bonds, or both.

There is also a “new” factor to be taken into account. Over the past three years, banks have been the “natural” buyers of government bonds due to the necessity of reducing risk but also and especially for regulatory reasons: to restore their liquidity and capital ratios. This provided for easier financing of national public debt (through the re-nationalisation of debt and natural or forced opportunities), but it also strengthened the link between banks and governments, a link whose disastrous consequences were already seen less than four years ago. But banks have become less active purchasers—especially in the core countries—now that these ratios are being met (or nearly met). The fact that purchases by banks are declining in the core countries while continuing apace in the peripheral countries is a strong argument in favour of QE by the ECB: the central bank must make up for the absence of the “northern” banks and confirm its support for the “southern” banks by mitigating the risk associated with the bank-government link.

How should large-scale QE be seen? An assessment of the potential impacts


1. Impact on short interest rates: very low for a (very) long time

The likelihood of key interest rates increasing within three to five years is virtually nil. As was the case in the US, as long as unconventional measures continue, raising key interest rates is out of the question. In other words, the lag between US and European monetary policy can only increase. This means the continued widening of short and long interest rate spreads between the two regions.

2. Impact on the foreign exchange market: toward a weaker euro

The prospect of large-scale QE considerably reinforces expectations that the euro will deteriorate over the coming months. In both the US and Japan, QE programmes led to a depreciation of the national currency—a goal that has been either implied (US and certainly the EU) or explicit (Japan). Supposing the QE is quickly announced, large in scope, and very well received by the markets, EUR/USD could come back under 1.10. It would be rather surprising if “the stars aligned” and the decline in the exchange rate was that significant. In other words, we are upholding our target of 1.15/1.20 for the EUR/USD exchange rate throughout 2015, with an inclination to go lower in the short term. To tell the truth, what matters for the eurozone’s growth is not really the EUR/USD exchange rate, but the euro’s actual exchange rate, i.e. the euro’s rate, weighted for trade with the zone’s partner countries. While the EUR/USD recently lost 10%, the euro’s current effective rate has moved little in recent months (see graph).

3. Impact on government bonds: a prolonged drop in long rates, despite extremely limited potential for the core countries

The adoption of QE also strengthens our expectation that long interest rates will be kept very low, and that additional lowering is possible. Increasing the size of the ECB’s balance sheet will likely lead to an additional decline in eurozone 10-year rates. To establish a €1 trillion-total programme, the ECB will undoubtedly be “forced” to complement current measures (TLTROs, ABS and covered bond purchases) with purchases of private or government bonds. If this were the case, eurozone bond rates would decline.

In contrast with OMTs, which involved purchasing bonds from countries “in distress” only—a measure that conflicts with the ECB’s statutes (and which can only be used as a last resort)—the ECB will probably purchase government bonds from all eurozone countries. But what will the terms be? Without a doubt, each country’s relative share of the ECB’s capital will be taken into account, as purchases related to the debt stock would be strongly biased in favour of the most indebted countries, which would be perceived as aid to the eurozone’s “bad pupils”. The ECB’s current aim is to justify such a measure by appealing to the need to fight against the menace of deflation, which threatens price stability—in other words, by fulfilling its sole mandate.

In this context, two factors should be taken into account:

  • Relative debt among countries,
  • Total net issuances.

The lower its debt and issuance requirements, the more a country stands to benefi t from QE. The table on the next page highlights the relative impact of a €500 billion sovereign QE programme, on all coupon securities, in which securities purchases would be pro-rated to the different countries in the ECB’s capital. We see that the countries benefiting the most from such a plan would be Germany (given the lack of financing requirements) and Austria (low debt and low financing requirements). It would also benefit Italy: true, government debt is high, but net issues are relatively low; in addition, the ECB’s purchases resulting from a €500 billion QE programme would be around two and a half times the amount of Italy’s net issues in 2015. France and Ireland, meanwhile, would benefit less in relative terms (higher debt and financing requirements). Thanks to this rarity effect, and provided the QE is generous and well-received, the German 10-year rate could reach 0.25%. Such a trend would also be accompanied by a reduction in government bond spreads, with a more favourable bias for countries with lower debt and lesser financing requirements, that would benefit most from an ECB purchasing programme.

This raises an important question about the ECB’s announcement strategy. There are several options:

  • Will it announce a phased QE, a bit like in the United States (first a (lowvolume) Q1, then a Q2, then a Q3)… or would it quickly announce a largescale QE? In the fi rst case, there could be disappointment (too little, too late), and in the second, the hope of renewed optimism on growth and a significant impact on equities, interest rates and spreads.
  • Will it announce a total amount without mentioning any particular maturity, or will it instead announce a total amount with a specific maturity at the same time? The first case would mean great uncertainty on the pace of purchasing, and the second would mean the option of reducing that uncertainty and deducing monthly purchase amounts by country.

All options are on the table. One thing is sure: the announcement strategy may turn out to be crucial, because it may be seen as reassuring – or worrisome – with regard to the financing of a given country. Some countries may have their net issues (or indeed their total financing requirements) covered by the ECB’s purchases alone. For others, depending on amounts and maturities, this may be less favourable. The numbers mentioned above, which are included in the table, clearly show the advantage, all other things being equal, of Austria, Germany and Italy over France and Ireland.

4. Impact on corporate bonds

QE involving private bonds would doubtless run into the market’s liquidity problems. That being said, whether the programme involves private or government bonds, it seems clear that spreads would narrow further, due to liquidity provided by the ECB, but also because of the decline in interest rates and the increased appetite for risk. Of course, preference should be given to relatively scarce securities (those with solid solvency and limited issuance programmes).

5. Impact on equity markets

Equity markets would also benefit from a government bond QE programme. We note five favourable factors: 1) the declining euro, 2) short interest rate levels, 3) long interest rate levels, 4) an improved growth outlook and 5) appetite for risk.

6. Impact on economic activity

History shows that monetary policies—conventional or otherwise—are effective if they can generate substantial wealth effects and if interest rates fall below economic growth expectations. QE would benefit economic activity if a number of transmission channels function properly:

  • The exchange rate channel: the solution is not simply a decline of the euro against the US dollar; a drop in the effective exchange rate of the euro is what is needed. But how do we get there? Firstly, the euro must be weaker than the yen or a number of emerging currencies. Indeed, QE in Europe should be seen in the context of Japan’s QE and the weakness of the emerging economies. Second, margin trends must not lead to the elimination of this competitive advantage. This would be harmful for economic growth. Businesses’ margins are inadequate in certain countries,  such as France.
  • The interest rate channel: the ECB can push interest rates lower, but they are already extremely low. Will QE and LTROs incite banks to increase their lending? What is certain is that credit conditions are continuing to improve, although not for SMEs, which depend heavily on banks.
  • The liquidity and wealth effect channel: the eurozone can count on these channels if the ECB’s measures are perceived positively, knowing the four-year delay between profits and valuations between the United States and Europe. It should be recalled, however, that the wealth effect through equities is much more effective (for better or worse) in the United States than in the eurozone due to the composition of individual investors’ portfolios.
  • The expected inflation channel is crucial. A rise in inflation would accelerate consumption and investment plans.

There is no doubt that large-scale QE would have something to offer the financial markets, which are expecting strong measures by the ECB. In the medium term, it is important that the transmission channels to the real economy function effectively, or else doubts and questions will resurface as to the eurozone’s ability to increase its growth potential, turn its back on stagnation and deflation and control the course of its public debt. The stakes are huge.

Ultimately, we are not (yet?) validating the extreme predictions detailed above on long-term rates (0.25% for Germany, 0.40% for France) and on sovereign spreads even though we remain prudent as to the immediate effectiveness of QE on the eurozone’s economic growth (we are not revising our growth forecasts upwards: 0.9% GDP growth for the eurozone in 2015; 1% in Germany; 0,7% in France), our strategies—which assume a favourable reaction to the implementation of large-scale QE—remain the following:

  • Short on EUR against USD
  • Long on peripheral government bonds
  • Long duration on core government bonds
  • Long on corporate bonds
  • Long on eurozone equities


Table: impact of a € 500 bn government bond QE programme




Short rates

During QE, maintenance of zero short-term interest rates for at least three years

3-month rate between 0% and 25 bp

Eurozone core long rates

Drop in all long rates because of government bonds purchased by the ECB, including eurozone core

German 10-year rate: 0.25%,
French 10-year rate : 0.40%

Government bond spreads

Support from the ECB reverses the asymmetry of risk, which will become favourable to bonds

There will certainly be tightening on government bond spreads and a decline in long interest rates, while QE on government bonds will be more beneficial to Germany, Italy and Austria than to France or Ireland.

Corporate bonds

Spreads would tighten further due to
1) the liquidity provided by the ECB,
2) the decline in interest rates and
3) the appetite for risk

Preference should be given to relatively scarce securities (those with solid solvency and limited issuance programmes).


Five favourable factors
1) the declining euro,
2) short interest rate levels,
3) long interest rate levels,
4) an improved growth outlookand
5) appetite for risk.

Preference should be given to equities which are sensitive to interest rates and exchange rates, which have high beta, and which could benefit from merger/acquisition transactions

What are the risks?

Four major risks remain:

  • Another slowdown in eurozone growth, which could be triggered by either a global economic slowdown or an inability to stimulate investment;
  • While markets would still react favourably to QE by the ECB, growth prospects could remain weak if the transmission channels for unconventional monetary policy remain blocked;
  • A rise in deflationary pressures;
  • The ECB could disappoint financial markets with measures either coming too late or which are considered insufficient.

Other risks include:

  • Misunderstanding of the Fed’s monetary policy;
  • Financial imbalances in some emerging countries due to the falling price of oil;
  • Currency war in Asia.






New QE would be amply justified











Toward purchases of government bonds, corporate bonds, or both?








Government bond purchases by banks are declining in the core while continuing apace in the southern countries: the ECB must make up for the absence of the northern banks while giving support to the southern banks









German 10-year rate: 0.25% target?







Will monetary policy regain effectiveness as a result of a government bond QE programme?






The risks have not disappeared




There is no doubt that large-scale QE would have something to offer the financial markets, which are expecting strong measures by the ECB





Equity portfolios

Bond portfolios

Diversified portfolios

  • Prefer eurozone equities
  • Stay neutral to underweight US
  • Beta of portfolio maintained to neutral
  • Emerging markets: country selection is key
  • Within emerging markets

- overweight Mexico, India, and Thailand
- neutral China, Brazil, Turkey, South Africa and Indonesia
- underweight Malaysia, Gulf States, South Korea, Greece, Russia, Taiwan and Chili

  • neutral cyclicals and pharma, Underweight consumer staples
  • Maintain long USD and GBP, short JPY and EUR
  • Maintain overweight position especially on European HY
  • Underweight US and UK (short duration)
  • Maintain overweight position on Italy and Spain
  • Maintain underweight/absent from peripheral countries having liquidity – solvency issues
  • Long duration on core eurozone
  • Overweight emerging debt of commodities consuming countries
  • Long financials
  • Maintain Long USD and GBP, short JPY
  • Stay neutral US equities
  • Prefer eurozone and Japanese equities
  • Overweight on EMG equities, prefer commodities consuming countries
  • Prefer equities to corporate bonds
  • Maintain long position on eurozone

HY corporate bonds (prefer Europe to the US)

  • Overweight position on sovereign bonds of peripheral eurozone countries
  • Positive on emerging debt in USD
  • Maintain Long USD and GBP, short EUR and JPY


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ITHURBIDE Philippe , Senior Economic Advisor
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Asset allocation: What would be the impact of large-scale European QE?
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