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Market hope for euro QE

Market hope for euro QE
August 29, 2014
Market hope for euro QE

Yields on 10-year bunds have fallen to 0.95 per cent following signs that the economy is stagnating. GDP in the eurozone did not grow in the second quarter; business confidence has fallen in both Germany and France; and purchasing managers report than economic growth slowed in August. The eurozone is "back on the brink of another recession", warns Erik Britton at Fathom Consulting. Such weakness has caused investors to reduce their inflation expectations. Markets are now pricing in sub-2 per cent inflation for the next five years, implying that they expect the ECB to consistently miss its inflation target.

Bond yields are also low because some hope that the ECB will respond to this weakness by following the Bank of England and Federal Reserve by beginning quantitative easing (QE). "Markets recognise the rising chances of large-scale asset purchases," says Investec's Philip Shaw.

Such hopes were bolstered by ECB president Mario Draghi last week, when he told a meeting of central bankers that "we stand ready to adjust our policy stance further".

But economists don't expect the ECB to announce any dramatic moves at next week's policy meeting. Holger Schmieding at Berenberg Bank believes the ECB would only adopt QE as "a backstop for serious emergencies". Most believe the ECB wants to wait to see the effects of the targeted longer-term refinancing operations (cheap loans to banks) which begin later in September before doing anything more.

What's more, even if the ECB does begin QE, it might not have dramatic effects. "The ECB alone will not be able to take the eurozone permanently away from low inflation," says Michala Marcussen at Societe Generale. It was for this reason that Mr Draghi called last week for European governments to use fiscal policy to stimulate their economies. But French president Francois Hollande's decision to sack ministers opposed to fiscal austerity has confirmed economists' fears that governments are committed to balanced budget fundamentalism.

Low European bond yields therefore might reflect not so much optimism that QE is coming, but despair that the region is locked into stagnation and that governments are unwilling and unable to combat it.