Europe Could Call It Quits on QE
The European Central Bank is adamant that its quantitative easing program will run until the end of September 2016. But it increasingly seems that the better-late-than-never initiative, which promises to pump at least 1.1 trillion euros ($1.2 trillion) into Europe's economy through the purchase of government bonds, is a redundancy.
The euro region's economy has recently been gathering a head of steam. And with Greece closer to reaching a deal on renewing its aid package than at any time since electing a new government five months ago, the threat of a euro breakup as a brake on business and consumer confidence looks set to evaporate.
An index of purchasing managers in European industries and services suggests the euro region may post growth of as much as 2 percent this year, according to Markit Economics, which compiles the business barometer. The index is at its highest in more than four years (a level above 50 indicates economic expansion):
Confidence in the common currency is rallying. In April, traders were making record bets that the euro would extend a slump against the dollar that's wiped almost 20 percent off its value in the past year. In the past two months, though, much of that speculation has been unwound:
Stock and bond markets are also signaling renewed confidence in the outlook for the euro region. The German stock market is enjoying its biggest two-day surge in almost three years. Yields on German government bonds repayable in 10 years or more, which typically climb when faster growth is expected to stoke inflation, have been heading higher for the past month, as this three-dimensional chart illustrates:
As those rising yields suggest, inflation figures for May point to the euro region having dodged the bullet of persistent deflation, with consumer prices rising at an annual pace of 0.3 percent after five consecutive months of either declining or unchanged prices. Moreover, ECB President Mario Draghi's preferred market measure of future inflation expectations -- something called the five-year rate on inflation swaps in five years' time -- has been making its way back toward the ECB's target rate of 2 percent this year:
All of this suggests that the ECB QE program, which envisages taking 60 billion euros of government debt out of the market every month, may turn out to be less necessary than was envisaged when it launched in March. That could mean the ECB, Europe's current fixed-income buyer of first resort, will step away from the market earlier than planned.
Bond investors are already on red alert about the Federal Reserve's promise to raise interest rates some time in the second half of the year. Now just suppose that coincides with a post-Greece spurt in European growth, which allows the ECB to consider scaling back the balance-sheet-boosting asset purchases it introduced against the inflation-fearing wishes of the German central bank.
Bond funds are preparing for a rocky transition, having already moved 8 percent of their clients' assets into cash, the most defensive stance against a possible decline in bond values since at least 1999. "We never realize what the tipping point is until after it happens," said Jerry Cudzil, who helps oversee $140 billion as TCW Group’s head of U.S. credit trading in Los Angeles and has stockpiled its most cash since the 2008 credit crunch. "We’re as defensive as we’ve been since pre-crisis."
The double whammy of a rate-rising Fed and a QE exiting ECB could prove great news for the global economic outlook -- and the worst of all possible worlds for the bond market.
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