ECB Quantitative Easing is not Credit Easing

I've made it clear my admiration for Draghi given his ability to get anything done given the political challenges he faces. But if Draghi plays chess the way he manages monetray policy, I would wager his opening would never be hypermodern and always a bit wooden and passive tempo. and predictable. His opening play here is not leading to money moving out on the risk spectrum into say stocks, but instead to money moving from one sovereign bond to another for a pick up in spread. ECB QE may only reinforce the current trend toward EU sovereign spread compression. And that may be all of it.

The ECB has a troubling trend to deal with. Over the last three years, the relative change in yield for German bonds was just as large as the move into French, Italian, and Spanish bonds.

If the current ECB objective is not to shore up sovereign financing costs, but rather credit easing—moving money into the hands of businesses and households—then the differential between risky EU sovereign and Bunds will continue to impair efforts to move money from state finances into private business.

Investors will merely use the ECB purchases as a way to pick-up the spread over Bunds. Generic Italian bonds still have a 100 bps spread over German bonds. That’s a very tempting move into risk when levered up given a determined ECB bid.

The relative change in CDS spread on a basket of large European banks (senior and sub issues, capitalization weighted) underperforms the relative change in government bond yields. The implication is that bank health remains suspect.

Balance Sheet Expansion and Risk Appetite

When the Fed expanded their balance sheet via QE I, it was to buy treasuries and agency MBS. These Fed purchases were meant to have a "portfolio" effect. By purchasing the short end of the treasury curve while simultaneously purchasing guaranteed agency MBS the effect would channel money out of the risk free assets desired in a time of uncertainty. It worked like this: from a price and yield perspective, Fed purchases of risk-free and guaranteed assets would be so unappealing that investors would have no choice but to take more risk in risky bonds, real estate, and common stocks. The added benefit was that large purchases focused at the short end of the Treasury curve would pin funding cost to the floor. This provided an implicit subsidy to insolvent global banking system and at the same time resurrected the repo market. These two are huge as they drive operating leverage and risk-taking.

The desired objective was credit easing: they needed to ensure that financing would be available for business given that money markets and capital markets showed signs of a complete lock-up. The Fed didn’t have to provide direct financing or buy any corporate paper if they could force everyone else into doing it. Maybe the Fed policy-makers truly are strategic geniuses that knew their actions would meet their objectives. Maybe the Fed was shooting in the dark by providing liquidity and financial markets took the path of least resistance and put the money to work. Either way, it worked.

The ECB is taking a similar approach. The ECB is buying €1.1 trillion of sovereign debt, €5 billion nibble at institutional and agency bonds, and winding up legacy asset purchase programs with €10 billion euro. If the ECB has the credit easing objective via a portfolio effect—getting financing available to businesses and households to reignite leverage and risk appetite—there is reason for concern.

The ECB’s efforts over the last three years have done nothing of the kind. You can make the case that it was not their objective at all; the end was to avert sovereign defaults among EU members. Fair enough. But the effects of ECB policies appear to reinforce the bid on sovereign debt, which is no way to get a recovery going. Real money did move yields on riskier EU sovereign bonds like Italy and Spain, but yields on reference bonds (read Germany) moved just as much.

Here’s the method. I’m not looking at total returns, just the relative change “(now-then)/then” in yields from 3 years ago to today. This doesn’t account for differences in issuance, liquidity, and technical flow just the change in level as an indication of bid.

Relative Change in Yield from Three Years Ago

Over the last three years, the relative change in yield for German bonds was just as large as the move into French, Italian, and Spanish bonds. If the current ECB objective is not to shore up sovereign financing costs, but rather credit easing—moving money into the hands of businesses and households—then the differential between risky EU sovereign and Bunds will continue to impair efforts to move money from state finances into private business. Investors will merely use the ECB purchases as a way to pick-up the spread over Bunds. Generic Italian bonds still have a 100 bps spread over German bonds. That’s tempting to lever up on when there is a constant ECB bid.

I took another step by comparing the change in CDS spread on a basket of large European banks (senior and sub issues, capitalization weighted) to the same government bond yield changes.


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