Economics & Strategy
European Outlook – Ending QE Was Easy, Normalizing ECB Policy Won’t Be: Challenges Around Timing, Personnel Changes and Global Spill-overs; Brexit is the Great Disruptor
— David Owen, Chief European Financial Economist
— Marchel Alexandrovich, European Financial Economist
The conclusion of Quantitative Easing (QE) closes an important chapter in the ECB’s history, but the end of net asset purchases does not mean an end to stimulus. With over €2.5 trillion of assets bought, significantly reduced proportions of sovereign debt in free-float circulation, much expanded TARGET2 National Central Bank imbalances, converging bank lending rates, and substantial capital outflows from the euro area into the rest of the world, the legacy of QE is undeniable.
In fact, the changes to reinvestment policy announced in December mean that in some sovereign bond markets QE effectively carries on next year, while other markets will already get a small dose of QT (quantitative tightening). The amendments to the ECB capital key weights, coupled with historic underbuying and overbuying of bonds, means that some national central banks (NCBs) will carry on adding to their holdings of sovereign debt in 2019. Meanwhile, other NCBs will not fully reinvest the cash generated through bond redemptions and will see their balance sheets begin to contract.
Through it all, however, the labour market continues to tighten and, crucially, wage growth across the euro area is accelerating. The pace of future policy normalization, however, will at least partly depend on the composition of the ECB’s Executive Board, and 2019 will see the departure of Mario Draghi (October 31), Peter Praet (May 31) and Benoit Coeure (December 31) – the three main architects of negative interest rates, QE and current forward guidance. The other significant change taking place in Europe next year is political, with the EU Parliament elections set to take place May 23-26, elections scheduled in Belgium, Finland (April 14), Portugal (October 6) and Greece, possibly Spain (May 26) and Italy.
Nothing politically, however, compares to the mess around Brexit. At present, there is gridlock in Parliament, with no obvious way forward. Eventually, Theresa May may have to concede to calls for a second referendum, but that could take more than 22 weeks to arrange, taking us well past the March 29 deadline and beyond the May 2019 EU elections. Rescinding Article 50, without taking it back to the country, could only be done as a final resort. It should also be remembered that if Theresa May wins the vote in Parliament, Article 50 still needs to be enshrined into UK law, requiring further debate and amendments. Ultimately, the final details of the UK’s future relationship with the rest of the EU may not be clear until well after the transitional phase has been extended out beyond December 2020.
Brexit is a Great Disruptor and, overtime, can be expected to lead to a significant change in the economic geography of the EU, including not just the UK and the euro area but also the EU-8. This change will create winners and losers, as supply chains in some cases are ripped up and in other cases evolve. Advisory, M&A and financing will follow, along with capital flows. From the UK’s perspective, it might be better to retain the design, R&D and intellectual property where value added is higher, and allow production lines that may be much more dependent on seamless UK-EU27 trade to move.
There remain substantial global imbalances led by the euro area with its very large current account surplus and the U.S. with its very large current account deficit, both of which are around $500 billion. Since the ECB started doing QE in 2015, there has been a significant asset allocation move out of euro area debt securities into higher-yielding U.S. credit and UK Gilts. This shift included net foreign selling of low-yielding German bunds and, in 2018, Italian bonds in size. What has also occurred since 2015 is over €500 billion of net euro area buying of U.S. debt securities – a substantial figure. Key questions for 2019 include whether these capital flows reverse as QE ends, which could have a significant impact on bond yields globally, and whether foreign buyers will return to Italy. FULL REPORT