Quantitative easing in Europe: early successes

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The efficient market hypothesis (EMH), which posits that market prices fully reflect all available information, has inspired a lot of controversy over the last half-century. The many attempts to refute it range from serious, such as behavioral finance or rigorous empirical testing, to humorous.[1] One of the challenges to the hypothesis’ holding in practice is information asymmetry. This intuitive argument asserts that EMH can only hold true if all market participants have access to the same information. Information asymmetry—and its fear—provides an interesting context in which to consider and compare two episodes in modern central bank monetary policy implementation: the taper tantrum of the summer of 2013 and the quantitative easing (QE) purchases of the European Central Bank (ECB) launched last week.

On May 22, 2013, in the midst of the third round of the US Federal Reserve’s (Fed) QE program, then Fed Chairman Ben Bernanke delivered a routine testimony to Congress. His intention was to reassure Congress and the markets that the program was working as expected and any decision to alter the rate of purchases would be data-dependent, a message he had delivered on many prior occasions. As the testimony went on, the market reaction was muted and generally positive, until Bernanke uttered this phrase:

If we see continued improvement and we have confidence that that is going to be sustained, then we could in — in the next few meetings — we could take a step down in our pace of purchases.

In all likelihood, in Bernanke’s mind this conditional statement was fully consistent with the main stance of the testimony, data dependence. However, the market completely ignored the conditionality, assumed that this was an (unconditional) signal for tapering in the next few meetings and embarked on a three-month sell-off during which the yields rose by roughly 140 basis points. Did the markets overreact to Bernanke’s testimony? With hindsight, it does appear so. However, at the time, the majority of investors were concerned about their informational disadvantage relative to the Fed, a large player engaged in open-ended purchases who was not constrained by the discipline of profit and loss, and their reaction to the Fed communication was to err on the side of caution.

The uncertainty surrounding the start of the ECB’s QE program on March 9, 2015 is of a different kind, at least for now. Like the Fed, the ECB made every effort to be as transparent as possible about the details of the program. The size, duration, pace, and security eligibility for the asset purchasing program as well as loss-sharing with the national central banks are all carefully spelled out. Furthermore, the ECB explicitly addressed some concerns about a unique risk the program is facing: whether or not the ECB will be able to see it through as planned. Two factors contribute to this risk. First, scarcity of government bonds, which amount to more than 80% of total asset purchases. The aggregate public budget deficit in the Eurozone is projected to decline over the next two years, reducing the net new issuance. As a notable example, Germany balanced its budget in 2014, and the new debt issuance in this country is expected to be negligible or even negative. Further complicating this is the concern that some institutions, such as insurers and banks, hold bonds for regulatory purposes and may be unwilling to sell at any price. Second, the presence of powerful dissenters in the ECB’s Governing Council. Jens Weidmann, a member of the Council and the head of Germany’s Bundesbank, reiterated his opposition to the program last week, arguing that an improving Eurozone economy renders the asset-purchasing program unnecessary.

The price action in the weeks leading up to the announcement and the subsequent launch of the program suggest that the markets priced in the risks associated with QE, but did not necessarily fear the informational disadvantage: the yields generally fell in this period and continued to fall this past week as early asset purchases proved a success .

Can this information equilibrium be violated in the months to come as the program proceeds? Easily. Among other things, some of the risks outlined above could materialize: purchases may run into a liquidity shortage, or dissenters may become more vocal. This makes impeccable communication crucial for the ECB to keep the market fears of asymmetric information at bay.

[1] A common joke on economic logic taken to an extreme: An economist is walking down the street with a friend. They notice a $20 bill on the ground, and as the friend tries to pick it up, the economist says: “Don’t bother. If it were real, someone would have picked it up by now.”

George Mylnikov

PhD, Head of Quantitative Strategies and Research at FFTW

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