QE is clearly one driver of the current low level of yields. Many hedge funds and investment banks are loudly calling for the ECB to extend QE to government debt. The arguments are rather more subtle, though, than many commentators suggest. For example, the ECB is already beginning to buy certain private-sector assets, such as covered bonds, asset-backed securities and potentially, corporate bonds. There are implications for the quality of the ECB’s balance sheet, which will concern many German policymakers. Nevertheless, reducing the spread between private and public sector bonds, as well as stimulating more securitisation by European banks, could give the ECB rather more bang for its buck.
The counter argument is that flows into bonds are not being driven by a mixture of short-term risk aversion plus central bank purchases. Instead they are correctly pricing in a more dangerous phenomenon, namely that the world economy is becoming trapped in a sustained period of very low economic growth and debt deleveraging after the financial crisis. Secular stagnation means QE has tried and failed. On that basis, neither the MPC nor the Fed manages to raise interest rates in 2015 as their economies do not reach “escape velocity”. The strength of domestic consumer spending and business investment is more than offset by the drag from weakness in Europe, Japan, the Brics and a decelerating China.
On this basis, we would expect to see the dash for yield to accelerate. The ECB’s attempts to limit its purchases to private-sector assets would be swamped by calls for wholesale buying of government debt, despite any German opposition. As the short end of the bond curve is already expensive, and indeed could well sell off, so there would still be value in long-dated bonds – the German 30-year bond yields about 1.8 per cent, with peripheral yields also attractive, and Italian 10-year debt currently yields 2.5 per cent. High-yield corporate and emerging market debt would respond, as would selected higher-yielding equities and real-estate assets to those investors searching for yield, in Europe or other regions. Expensive valuations would move higher.
