BUY on the rumour, sell on the fact. That old stockmarket saying didn't really apply this week, unless you count the euro. The European Central Bank was widely expected to start quantitative easing (QE) and it duly did so, but stockmarkets still managed a post-announcement rally. Perhaps it was the size of the programme - €60 billion a month - that impressed investors - or the potentially open-ended nature of the programme - at least until September 2016 but until the 2% inflation target is reached.
How is QE designed to work? The most obvious impact is to reduce bond yields but as this week's column points out, bond yields are already negative in parts of the euro zone. If companies aren't borrowing now, will a few more basis points off yields help? Reducing yields in the periphery is much more helpful, although as Mario Draghi pointed out in his statement, the puchases will be spread across the zone
The purchases of securities issued by euro area governments and agencies will be based on the Eurosystem NCBs’ shares in the ECB’s capital key.
And these weights are roughly based on GDP. So the big countries bonds' will be bought along with small. Lower bond yields also create a portfolio rebalancing effect, of course, as investors despair of low-yielding government bonds and opt for corporate bonds and equities. And this can boost consumer confidence, although this works much better for the rich than the poor.
The second potential impact is on inflation expectations. If people trust the central bank to deliver, then they will believe in the 2% inflation target and act accordingly; Goldman Sachs says that five year/five year inflation expectations (what the markets think inflation will be from 2020-2025) are up to 1.74% from 1.48% not that long ago. One has to wonder, however, about the credibility of these targets; the Bank of England missed its target on the upside for several years and is now missing it on the downside. When inflation was above target, it was easing policy; now it is below target, it is doing nothing. And the Swiss shift hardly boosted the cause of central bank credibility.
The third effect is on the exchange rate. The euro fell in the wake of the announcement and is around €1.125/$ now. Capital Economics says that
We have long insisted that a weaker currency is the primary channel through which QE might work in the euro zone so the further drop below 1.13 (at the time of writing) taking the total fall against the US dollar since May to almost 20% and even the trade-weighted decline to over 10% is clearly welcome. On paper at least, these falls could have significant economic effects, particularly when combined with those of the drop in oil prices.
A fall in the euro will of course push up import prices and add something to inflation expectations on its own. In market terms, it seems clear that 2015 is already set to be dominated by currencies. Last week's Swiss shock was such a surprise because it was a revaluation, not a devaluation; it has had a knock-on effect today as Croatia decided to tie its currency to the Swiss franc as a way of helping out those citizens who had taken out mortgages in the Swiss currency. (Why on earth would you mismatch your assets and liabilities in such a way? Who advised these people?) The Swiss decision was clearly taken in anticipation of the ECB's move.
All this is the result of differential monetary policies (America and Britian ceasing QE; the ECB and Japan pursuing it) round the world at a time when deflation fears are widespread. Tie your currency to that of another and you import its monetary policy, even though that might not be appropriate. In effect, this is the underlying issue of the Greek election; by adopting the euro, the old option of devaluation was ruled out and a crisis resulted in cuts in nominal wages and prices, a much more difficult shock to absorb. A Syriza election on Sunday could give traders yet another reason to sell the euro.