Portfolio rebalancing, delayed

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Quantitative easing (QE) in the Eurozone has gotten off to a very strong start, judging by its financial market effects. For example, real yields in the Eurozone have continued to decline even after the immediate drop in yields typically associated with the announcement of a QE program. By contrast, on average across the three QE programs in the US and the two QE announcements in Japan, real Treasury and JGB yields tended to drift higher once those programs got under way. In terms of currency impact, on a trade-weighted basis, the euro’s depreciation since the announcement of QE has been roughly in line with the Japanese yen’s depreciation following the Bank of Japan’s QE announcements, and certainly more than that experienced by the US dollar after the announcement of QE programs in the United States. And in local currency terms, equity market performance in Europe has been similar in scope to the rallies seen after Japan’s two QE announcements as well as QE1 in the US – and larger than the equity rallies following the QE2 and QE3 announcements. All in all, European Central Bank (ECB) policymakers have to be pleased with the financial market effects of their most recent policy initiative.

There are a number of reasons why the ECB’s QE program has had such a powerful effect on financial markets. Perhaps most importantly, investors have gradually come to appreciate that the ECB program is open-ended, with an implicit commitment to extend purchases beyond September 2016 if necessary. This design feature, signaled by President Draghi in many of his public remarks on QE, evinces a strong commitment to continue with balance sheet expansion until inflation is on a sustained path towards the ECB’s target. Second, the ECB’s clarification that it would buy negative-yielding government bonds down to the rate on its deposit facility has also been interpreted as a strong signal of the commitment to make good on purchase objectives. And imposing a yield floor on purchases has also increased expectations that the ECB and many of the national central banks will eventually need to extend their purchases further out the yield curve in order to source bonds. This implies that the Eurosystem may eventually remove more duration from the market than initially anticipated, which increases downward pressure on the term premium and real yields on sovereign bonds.

In contrast with these strong effects on financial markets, there is limited evidence thus far of active portfolio rebalancing by various financial market actors. For many European investors, there are few compelling reasons at this point to sell European government bonds (EGBs) in favor of risk assets. Banks, for example, still have incentives to hold low or even negative-yielding government bonds, as the alternatives are not particularly attractive. Holding cash at the ECB at the -20 basis point deposit rate would leave them worse off. Purchasing risk assets would bring with it a higher capital charge, which many European banks remain unwilling to incur. And selling EGBs to grow loan books is also challenging in a fragile economic recovery characterized by weak demand for credit. Similarly, insurance and pension funds have a natural need for long-duration assets, and regulations incentivize them to meet these needs in EGBs. Finally, across these domestic investor classes, there is considerable skepticism that QE will succeed in reflating the economy in the absence of decisive pro-growth fiscal policies. This skepticism limits the impetus for shifting into riskier assets. At the very least, until there is greater convergence of yields to the rate on the deposit facility, expect European institutional investors to await further mark-to-market gains on their EGBs before engaging in meaningful rebalancing.

International investors are likely to be the more active portfolio “rebalancers”, and anecdotal reports suggest that they have actively increased their exposure to European equity, duration and credit risk since expectations for QE began to firm last fall. As occurred in the US and elsewhere, these first movers tend to anticipate eventual portfolio rebalancing by other investors, and position accordingly. Finally, over time, central bank reserve managers will likely reduce their exposure to the Eurozone rather than engage in meaningful portfolio rebalancing across European assets. Broadly speaking, conservative liquidity and credit quality guidelines constrain this investor class from significantly extending duration or moving down the credit spectrum to pick up yield. Their gradual portfolio rebalancing will most influence financial conditions through exchange rate effects.

That portfolio rebalancing is occurring slowly does not mean that QE is having less than the desired impact. The international experience with QE shows that such effects happen only gradually. For example, a study by the Bank of Japan showed that through the end of 2013, their own QE program had led to some rebalancing by domestic banks (into loans) and international investors (into loans and equities), and had no discernible impact on the holdings of insurance companies and public and private pension funds.

Even as portfolio rebalancing requires time to gain momentum, the ECB now faces another challenge as relates to the ultimate success of its QE program – rising uncertainties over Greece and the potential for a default and exit from the Eurozone. Most investors do not see a default and exit as their base case, but the uncertainty surrounding the situation will only serve to detract from many of the positive effects of QE. Greece risk may lead core European sovereign bond yields to decline further, but it will be due to flight-to-quality flows and lower growth and inflation expectations, in contrast to the term premium declines that engender portfolio rebalancing. Similarly, reduced risk appetite and, at the extreme, increased redenomination risk could lead to a rise in peripheral sovereign yields that will undo much of the positive effect of QE on debt sustainability dynamics in peripheral countries. And if skepticism that QE will eventually lead to reflation has delayed portfolio rebalancing by many institutional investors, the uncertainty engendered by Greece will only cause this rebalancing to be put off for longer. Realistically, the Greece situation threatens to undermine much of the good done by QE thus far and lengthens the runway to meaningful portfolio rebalancing, and ultimately jeopardizes the ability of the ECB to affect a sustained upward adjustment in the path of inflation by its anticipated end-date for QE.

Steven Friedman

Senior Investment Strategist

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