It has been less than three months since the Federal Reserve ended its quantitative easing program, and now the European Central Bank has stepped up to take its place and flood the world with newly printed money. The ECB announced its plans to begin purchasing EUR 60 billion ($68 billion) of debt per month this March and continue through September 2016. The total size of this purchase program as currently contemplated is EUR 1.1 trillion ($1.2 trillion) and would increase the size of the ECB's balance sheet by about 50% to more than EUR 3 trillion. However, members of the ECB have already stated that if the ECB is not seeing its intended results, then the asset-purchase program could last even longer. The intent of the QE program is to bolster the economy in the eurozone, revive inflation, and raise asset prices.
The monthly purchases will reportedly consist of EUR 45 billion of sovereign bonds, EUR 10 billion of asset-backed securities and covered bonds, and EUR 5 billion of bonds issued by government institutions and agencies. In total, that equates to EUR 855 billion of sovereign debt, EUR 190 billion of ABS, and EUR 95 billion of agencies. Each individual central bank will buy its own sovereign debt in proportion with its capital in the ECB and as much as 20% of the total amount will be subject to a risk-sharing plan if any of the underlying debt defaults.
The near-term economic effect of the program is likely to be modest. The ECB has long made it known to the markets that it was headed down this path, and the fixed-income markets have already priced in much of the program's impact. Long-term interest rates have been steadily declining across the eurozone and are hitting historical lows. For example, the yield on the German 10-year bund has dropped to 0.36% and the 10-year French OAT is currently 0.54%. The lower-rated peripheral eurozone countries have also benefited, as Spanish and Italian 10-year bonds are trading at 1.38% and 1.53%, respectively. Among other European countries whose debt is denominated in their own currency, 10-year U.K. gilts are yielding 1.48% and Swiss 10-year bonds are trading at a yield of negative 0.26%. Some investors are willing to purchase Swiss bonds at a price that locks in a loss as a long-term bet that the Swiss franc will continue to appreciate versus the euro, whereas other investors are willing to purchase shorter-dated euro-denominated debt at negative yields just to protect against the risk of deflation in the euro. There is reportedly around EUR 1.4 trillion of euro area government bonds that are currently trading at negative yields. Most of these bonds are issued from the core European governments with maturities of up to 5 years. This appears to be unprecedented in any other period.
Considering that interest rates are already at historical lows, it is highly unlikely that even lower interest rates will stoke the flames of new economic growth. However, the low interest rates are likely to help drive asset prices higher. Unfortunately for most Europeans, stocks and bonds are not as widely owned by individuals as in the United States, which will mute the impact of the wealth effect. The other asset class that will benefit from low long-term rates is real estate. This in turn will help to increase the collateral value that the European banks lent against before debt crisis. As the collateral value securing banks' loan books had declined over the past few years, those banks have been especially wary of making new loans or refinancing existing loans. As the value of the real estate appreciates, it will allow the banks to roll over loans that otherwise may not have had enough collateral value to refinance. This should help to bolster the banks' balance sheets, improve recovery values for loans that do end up in default, and in turn increase credit availability in the eurozone.
The greatest near-term impact of the QE program has been the devaluation of euro versus other currencies. Since the announcement, the value of the euro in dollar terms dropped 3.5% in just a few days. In anticipation of the QE program, the value of the euro had already been steadily dropping, falling 7.4% since the beginning of the year and more than 17% over the past 12 months. Currently, the euro is at its lowest exchange rate to the dollar of the past 11 years. From a business point of view, the sliding euro will help improve exports as goods that are denominated in the devalued euros are cheaper in foreign currency terms. From a consumer's point of view, the devalued euro will drive up the cost of any imported products and act as a headwind on consumer spending. While increased credit availability and rising exports should help to revive the European economy, this monetary program would have been more effective if it had been launched in conjunction with fiscal and economic reforms to address the structural economic impediments in the eurozone.
Effect on Corporate Bond Markets
The minuscule interest rates on fixed-income securities in Europe as compared to the U.S. will probably keep interest rates on U.S. Treasury bonds from rising in the near term and may even push U.S. interest rates down further. For example, the yield on the 10-year U.S. Treasury is currently 1.82%, almost 150 basis points higher than the 10-year German bund. U.S. Treasury bonds offer global investors a significant yield pickup over sovereign European debt and the safety of being denominated in U.S. dollars as opposed to risking losing additional purchasing power if the euro continues to slide against other currencies. In addition, the creditworthiness of the U.S. is still multitudes higher than that of BBB rated Italy and Spain, yet the yield on U.S. bonds is higher than both of those countries.
With interest rates on sovereign bonds in developed markets at such low rates, corporate bonds should perform well on a relative basis. As the ECB purchases sovereign debt and ABS, the proceeds will need to be reinvested somewhere, and the path of least resistance will be the corporate bond market. This demand is likely to drive corporate credit spreads tighter. As corporate credit spreads in Europe contract, it will naturally pull credit spreads tighter in the U.S. Investors who can purchase debt in either euros or U.S. dollars will gravitate toward the debt that offers both greater spread and a higher all-in yield, which is currently the U.S. dollar-denominated debt.
As credit spreads tighten, performance of corporate bonds between sectors is likely to be bifurcated in the near term. The sectors that will perform the best will be those that are not exposed to low oil prices or basic material commodity prices (such as iron ore, coal, and copper). Bonds in the energy sector currently offer the highest spreads for their rating, but unless oil prices recover substantially in the next few months, we expect that defaults in the energy space, especially among the smaller service companies, will pick up this fall. Most exploration and production companies have hedged enough of their 2015 production to make it through this year, but as their hedges begin to expire, those E&P companies with higher break-even costs on a per barrel of oil basis will start to default in 2016. These defaults could continue to pressure the entire energy sector and force spreads to widen even further, especially as the value of oil fields will be depressed and recovery values will be slim.
