Banking interview questions: 'What does the ECB's QE mean for markets?'
In the unlikely event that you missed it, the European Central Bank has spiked the punch bowl and joined the quantitative easing party. Starting from March 2015, the ECB will be buying €60bn of euro-denominated, investment-grade bonds (bonds with a low risk of default) issued by Eurozone governments. This purchasing programme will continue until September 2016, at least.
Why is the ECB doing this? As Sony Kapoor, visiting professor at the London School of Economics and managing director of think tank Re-Define, points out, it's mostly to counter deflation. In December 2014, inflation in the eurozone turned negative at -0.3%, which was way below the ECB's inflation target of 2%. Deflation is bad: it discourages current consumption (because consumers think products will be cheaper tomorrow). It also frightens away investors (Goldman Sachs says Europe has been "uninvestable" due to deflationary risks). By boosting inflation the ECB hopes to increase consumption, to increase investment in the eurozone and to increase economic growth.
By increasing economic growth and buying eurozone government bonds, the ECB also hopes to reduce investor jitters about highly indebted governments (like Italy and Greece). This should also encourage investors to direct money into the euro area.
QE's most obvious impact is on the euro: the currency has already fallen to its lowest level against the dollar for 11 years and will likely continue to slide. But it's not just foreign exchange markets that are being touched by QE, it's equities and bonds too. So what do you say in your banking interview when you're asked how QE will affect the markets? Try this...
What does Eurozone QE mean for the corporate bond market?
Analysts at UBS suggest that QE could be a good thing for some areas of the bond market. To be specific, it could be good for risky corporate bonds. With the European Central Bank buying the debt of eurozone governments, the 'yield' on government bonds will stay low. So too will interest rates across the eurozone. As a result, bond investors will need to find different products to invest in if they want to make a good return. Those products may well be so-called 'high yield bonds' - or bonds issued by companies which might never pay them back and which therefore pay a higher rate of return than safer bets.
"The beneficiaries will be higher-beta, higher-yield corporate entities as the hunt for yield goes on," say UBS analysts. In plain language, this means slightly risky corporate bonds which rise and fall in line with the market ('high beta') will be in demand in 2015 as investors search for returns. Companies issuing these bonds are in luck. So are high yield professionals working in European investment banks. - It looks like banks' recent appetite for hiring European high yield sales and trading professionals will continue unabated.
What does Eurozone QE mean for equities markets?
QE is also a good thing for equity markets. Stocks rallied when the policy was announced, and not just in Europe - in Asia too.
Barclays analysts point out that the ECB's move has helped calm markets and to increase investor optimism. January has been a difficult month, what with "jitters in the oil market" and "central bank surprises" (mostly Swiss National Bank's unexpected move, but also two rate cuts from Denmark and surprise rate cuts from Canada and India). Thanks to the ECB's QE, Barclay analysts say we now have a, "euphoric rally in equities, a sharp rise in Treasury yields and a decline in financial volatility." They add that, "This was a result of the confidence boost provided by QE and the sharp turnaround in economic expectations."
Analysts at Goldman Sachs are predicting that "cyclical stocks" (which rise most in rallies) will do best from QE. They suggest buying 'consumer cyclicals' like luxury clothing companies Burberry and Salvatore Ferragamo, which should benefit if the economy grows and consumers feel richer.
Will QE have a lasting effect?
Will QE really work? Looking across to the effects of QE in the US, analysts at Barclays suggest markets get QE fatigue after a while. When the US Fed implemented its first round of QE, they point out that there was, "a euphoric rally in equities, a sharp rise in Treasury yields and a decline in financial volatility." They say that this was all the result of, " the confidence boost provided by QE and the sharp turnaround in economic expectations." By the third round of US QE, however, the effect wasn't quite the same: "QE3 was followed by a slight downgrade in consensus growth forecasts, as well as a sell-off in equities and a rise in implied volatility."
Barclays says the eurozone isn't out of the woods yet. The experience of the US suggests that if QE is to work, it will need to improve confidence and to improve growth expectations. However, 2015 is set to be a difficult year - elections in Greece and then Spain and the UK threaten to increase volatility in the financial markets and may spook investors. The ECB's good work could yet be destroyed in the process.