Less talk, more walk

Economy | Sat 21 Feb | Author – Business & Finance
Switzerland Euro

As the dust settles on January 2015, looking back, it was the month that Europe’s central bankers brought investors on a merry dance, writes Aidan Donnelly.

Expectations have been building for many months that we would see a Quantitative Easing (QE) programme launched by the European Central Bank (ECB).

Given the well-chosen and frequently re-iterated words from the various elements within the ECB, it was definitely a case of ‘when’ rather than ‘if’ such a programme would be initiated.

Since Mario Draghi, president of the ECB, uttered the immortal words: “We will do whatever it takes” in July 2012, investors have been looking for ‘less talk and more walk’.

The introduction of the Long Term Refinancing Operation (LTRO) and the Targeted LTRO (TLTRO) gave the ECB short-lived reprieve along the way but by late last year investor appetite for QE would not abate, forcing the Draghi reassurances that the ECB ‘will do what we must’.

Walking the walk

The big debate in the markets in the days leading up to the decision was based around whether it would be more positive to see a bigger size of QE announced, but with each member central bank technically responsible for the losses or a smaller size where any future losses were fully mutualised.

The press reports from the likes of Der Spiegel and the FT suggested that the ECB was possibly going to bow to German pressure to have member state’s central banks responsible.

Whether this mattered or not was a moot, if well debated, point. For some, the fact that other mechanisms within the ECB would ensure the risk of the programme gets spread across member states meant that any move would be mostly cosmetic.

Others argued that it cut to the very heart of the idea that we have a full monetary union.

Size matters

As the day of the decision approached the commentary focused on the likely monetary size of the package and what types of securities would be included. An article in The Sunday Times noted that ‘a bitter row had erupted between the ECB and Germany over a giant stimulus programme to save the eurozone from a deflationary crisis’. The report suggested that a programme worth up to €600bn was in play, however German and ECB officials ‘remain at loggerheads over the basic points of the plan’.

A Bloomberg survey showed the majority of respondents expected the programme to be nearer the €550bn mark. On the day before the announcement, there had been some well-placed rumours that the initiative would entail the purchase of €50bn of securities each month, but in the tradition of finance ministers always keeping some surprises in the bag for budget day, the actual plan, when announced, was even better.

In fact the programme has proven to be bigger, faster and more explicit than the market expected. It involves the ECB expanding its purchase programme to buy €60bn of assets each month, and will include euro-denominated, investment-grade securities issued by euro-area governments and agencies and by European institutions.

While the intention is to keep the programme in place until the end of September 2016 at least, according to the ECB it will be “conducted until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term”.

Therefore, should inflation remain below target or show little upside momentum, the ECB has the scope to continue to purchase beyond September 2016.

Alternatively, the bank could end the programme if inflation picks up. In this context, it is worth noting that even after six years of on-and-off QE programmes by the Federal Reserve, US core inflation has continued to run below its 2% target.

What will it all mean?

Following the ECB decision, there was further weakness in the euro and rallies in European equity and bond markets.

As to the longer-term question of whether the initiative will work, some commentators believe that a lack of structural reform, increasing inequality and low fiscal injections are the reasons for Europe’s current predicament, and that this plan will changes none of those issues and in fact, that it could even prevent other improvements taking place.

With the changing political landscape in Europe, particularly most recently in Greece, the problems for the eurozone are varied and this move will not be a panacea for all ills, but for now, the market’s reaction suggests that hope is trumping experience.

A Swiss surprise

If you were to look up the ‘required skills’ segment in the job description of a central banker, you would probably find things such as consistency of thought, strong communications skills and in general a desire not to be the person who jumps out from behind a tree and shouts ‘surprise’ to financial markets.

For the last few years, we have seen central banks on both sides of the Atlantic at pains to telegraph their future decisions well in advance and to ‘stay on message’ when possible thereafter. However, announcements in mid-January suggested that the ‘gnomes’ in the Swiss National Bank (SNB) did not attend their classes in central bank etiquette.

No safe haven

In the wake of the financial crisis, the Swiss franc was viewed as a safe haven currency, particularly in the European context, and as a result strengthened considerably against the euro.
In an attempt to temper this strength, and help the country’s export and tourism industries, the SNB implemented a ceiling on the exchange rate in September 2011.

Since then, it has been vigorously maintaining it by action and word, even as recently as its meeting in mid-December when it committed to preventing the currency appreciating beyond 1.20 to the euro and vowed that it would enforce the policy with “the utmost determination” – however, on January 15th that resolve disappeared. In a decision that shocked markets, the SNB announced the removal of the ceiling, leading to a ‘once in several generation’ move for the Swiss franc.

The price action was dramatic, with the franc immediately appreciating some 29% intraday against the euro and touching a record low of CHF0.852 before closing at CHF0.975 at the end of the European session – still around 19% stronger on the day.

Dramatic reaction

The reaction in the equity market was equally dramatic, with the Swiss index falling over 8% on the day. As markets got to grips with what had happened, the worry for some commentators was that if the SNB can make such a dramatic ‘volte-face’, then other central banks could follow at some point.

Others will argue the wider point of the perils once you artificially impact a market – that changing course can be very painful.

What are the implication for the man and woman on the street? Well let’s just say I hope you all enjoyed those bars of Toblerone at Christmas as they are now 20% more expensive.

Aidan Donnelly

Aidan Donnelly is a senior equity analyst at Davy Private Clients.

Views expressed in this article reflect the personal views of the author and not necessarily those of Davy or Business & Finance. Follow him on Twitter @aidandonnelly1.