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On Thursday, the European Central Bank (“ECB”) announced its much speculated about quantitative easing (“QE”) program.
Over the last several years, central banks around the globe have been engaging in aggressive balance sheet expansion policies by purchasing government bonds (or other assets), driving down interest rates and increasing the money supply. The ECB, however, has been reluctant to act. As a comparison, while the Federal Reserve’s balance sheet nearly doubled in size over the last 3 years through aggressive purchasing, the ECB’s was basically cut in half.
And arguably, the Eurozone has suffered for it. Below we compare several economic indicators for the U.S. versus the Eurozone.
|2014 Q3 QoQ GDP Growth||5.0%||0.2%|
Anemic growth and high unemployment are concerning, but it appears that the risk of collapsing prices (seen in the negative inflation rate) really drove the ECB to act. You just have to look at Japan to see the damage that a deflationary spiral can cause.
Expectedly, the announcement drove down government bond yields and the euro fell to an 11-year low against the dollar.
The question remains, however, is it “too little too late?” Government bonds in European countries are already at decade lows. The 10-year yield on French and German government bonds, for example, fell precipitously over the last year and sit at 0.54% and 0.36% respectively.
The theory of QE is that driving down government bond yields simultaneously reduces the cost of borrowing as well as forces investors to put capital to work in riskier investments to achieve an attractive return profile. The falling yields over the last year are either (1) due to speculators trying to front-run an expected QE plan, or (2) a sign that investors have completely lost faith in the Eurozone economy and are foregoing any risk. Without much room to push yields lower, let’s hope we’re not in scenario #2.
While the dust has not settled, the market took the news as an optimistic sign for future growth, with global equities rallying. Only time will tell.