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Investment Strategy
March 2015
Private Banking – Investor ‘Extra’
A primer on Quantitative Easing (QE)
With the European Central Bank’s announcement of further sovereign bond purchases back in January,
yet another developed economy central bank has now embarked on a fully fledged Quantitative Easing
program. This again prompts investor questions around what exactly the objectives behind QE are and
how it benefits the economy?
In simple terms Quantitative Easing refers to a situation where a central bank purchases assets (these
can be government bonds, corporate bonds, even equities). It is known as an ‘unconventional’ monetary
policy i.e. it tends only to be used as a policy tool once official short term interest rates (the ECB main
refinancing rate for example) approach zero. QE can impact on the economy and investment markets in a
number of direct and indirect ways.
Direct QE ‘impacts’
Lower bond yields
It tends to drive up the prices of the purchased assets – by driving up bond prices for example, it will
lower bond yields relative to where they would have been in the absence of central bank purchases. This
ultimately reduces the interest rates at which countries, companies and individuals can borrow at.
The first example of how this can benefit the economy can be seen in chart 1 which shows the downward
impact QE in the US had on US mortgage rates. By putting downward pressure on mortgage rates QE
reduced mortgage costs for new home purchasers and allowed existing owners to refinance at lower
rates, thereby reducing their monthly mortgage outlay. So in short it should benefit consumer spending
(lower mortgage outlays) and could also benefit US investment (more home purchases = stronger
construction levels).
Chart 1: Example of QE Impact, US 30 Yr Mortgage Rates
8%
6%
4%
US Mortgage rates moved lower
once QE in the US commenced!
2%
US QE periods
Source: Bloomberg, March 2015
US 30 Year Mortgage Rate
Dec-14
Aug-14
Apr-14
Dec-13
Aug-13
Apr-13
Dec-12
Aug-12
Apr-12
Dec-11
Aug-11
Apr-11
Dec-10
Aug-10
Apr-10
Dec-09
Aug-09
Apr-09
Dec-08
Aug-08
Apr-08
Dec-07
0%
A second example is the impact of QE on government borrowing costs. With super low interest rates
governments have now far less interest costs on ‘new’ borrowings than likely would have been the
case in the absence of the ECB’s loose monetary policy and Quantitative Easing. Clearly this takes
some pressure off the public finances of countries in the region. It also makes it super cheap to
borrow to invest in capital intensive projects which can add to the productive capacity of the economy,
assuming the sovereign has the scope to take on further borrowings.
Chart 2: Irish 10 Year Government Bond Yields
Mario Draghi began to drop QE hints
last summer - Euro area government
bond yields have collapsed since
then!
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Source: Bloomberg, March 2015
Larger monetary bases (money goes into the financial system, in exchange the central bank
receives the purchased assets)
A second direct impact QE has is in increasing the economy’s monetary base i.e. the total amount of
an economy’s currency in public hands and in commercial bank deposits with the central bank. Chart
3 shows that during QE periods the monetary base expands. Generally there is a loose positive long
term relationship between changes in the monetary base and changes in inflation i.e. all else being
equal if there is a substantial increase in the monetary base this can lead to rising inflation. So in time
one would expect QE to have a positive impact on inflation. However how quickly this transpires
depends crucially on how quickly the stock of money is turned over in the economy through bank
lending. Since the global banking system has been slow to recover following the global financial crisis
and credit growth has been muted, the increase in monetary bases around the world has not (as yet)
translated into higher inflation.
Chart 3: US Monetary Base during QE periods
5,000
4,000
3,000
2,000
1,000
US QE periods
Source: St. Louis Federal Reserve, March 2015
US Monetary Base (US$Bn)
Dec-14
Aug-14
Apr-14
Dec-13
Aug-13
Apr-13
Dec-12
Aug-12
Apr-12
Dec-11
Aug-11
Apr-11
Dec-10
Aug-10
Apr-10
Dec-09
Aug-09
Apr-09
Dec-08
Aug-08
Apr-08
Dec-07
0
Indirect QE ‘impacts’
Positive Wealth Effects
Most investment assets (equities, property, bonds) are valued with reference to interest rates. For
example, equities and bonds are often valued by discounting their income stream (dividends in the
case of equities or coupon payments in the case of bonds) based on prevailing interest rates. Given
that QE tends to be associated with lower interest rates, then all else being equal a loose monetary
policy and/or QE should be accompanied by higher valuations for investment assets.
QE can indirectly benefit the economy to the extent that higher equity/bond/property prices boost
household wealth, improving confidence levels and potentially leading to stronger consumer
spending, investment and ultimately economic growth
Improved Business/Consumer Confidence
Linked to the point above, lower and less volatile interest rates (thanks to Quantitative Easing) can
help consumer and business confidence. This can promote higher levels of consumer spending and
business investment which can again ultimately boost economic growth rates.
Currency Movements
We’ve seen that lower interest rates tend to boost asset class valuations, but what does it do to
exchange rates? Generally finance theory posits that in the long term economies with higher interest
rates tend to be associated with depreciating currencies (so as to eliminate risk free profit aka
arbitrage opportunities).
Clearly the recent moves in the EUR/USD exchange rate show that sometimes market movements fly
in the face of financial theory. At present the likelihood of higher interest rates in the US in the next 12 years (relative to those in the Euro area) is driving the US dollar higher, not lower, not only versus
the Euro but against most global currencies (see chart 4 for how the USD has performed versus a
basket of its trading partners in recent months).
Chart 4: US Trade Weighted Dollar Movements (Rebased to 100)
140
120
100
Dec-14
Aug-14
Apr-14
Dec-13
Aug-13
Apr-13
Dec-12
Aug-12
Apr-12
Dec-11
Aug-11
Apr-11
Dec-10
Aug-10
Apr-10
Dec-09
Aug-09
Apr-09
Dec-08
Aug-08
Apr-08
Dec-07
80
However while this situation persists it is a boost to the Euro area economy and the efforts of the ECB
to defeat deflation in a couple of ways
•
•
All else being equal a lower euro means Euro area exports are ‘cheaper’ to purchase in foreign
countries – stronger export growth adds to economic growth
All else being equal a lower euro means imports into the Euro area cost more – this should in time
help inflation rates improve, exactly the sort of outcome the ECB is hoping for.
Tom McCabe, Global Investment Strategist
Disclaimer
Bank of Ireland Private Banking Limited (BOIPBL) believes any information contained in this document to be
accurate but BOIPBL does not warrant its accuracy and accepts no responsibility whatsoever for any loss or
damage caused by any act or omission made as a result of the information contained in this document. Any
investment, trading or hedging decision of a party will be based on their own judgement and not upon any view
expressed by BOIPBL. Reference in this document to specific securities should not be construed as a
recommendation to buy or sell these securities, but is included for the purposes of illustration only. You should
obtain independent professional advice before making any investment decision. Any expression of opinion
reflects current opinions of BOIPBL as at March 2015. Any opinion expressed (including estimates and
forecasts) may be subject to change without notice. This publication is based on information available as at
March 2015. For private circulation only. Not to be reproduced in whole or in part without prior permission.
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