The European Central Bank early Thursday morning announced that it would begin its own asset-backed purchasing program much like the quantitative easing programs that the Federal Reserve has embarked upon since the global financial crisis in 2008. Details are scant, but the program is likely to be small scale but could possibly expand in future months if systemic risks and signs of decelerating growth in the eurozone rear their ugly heads.
How this has influenced asset classes is clear, and the reaction in bond and stock markets should be deeply familiar to anyone who has tracked the markets since 2009.
1. European Stocks
Stocks in the eurozone rallied and throughout the EU strength as apparent. While steady interest rates at the Bank of England helped the FTSE 100 (ISF), the real action was in the Euro Stoxx 50 (FEZ), which rose over 1% on the news and may climb higher if the QE program is successful.
The rise in stock prices makes sense if you think about the capital flows that an ECB QE program will suggest. A lot of cash is sitting in bank accounts throughout the EU, providing little investment into economic activity. With asset purchasing and cut interest rates, the ECB will encourage more investors to search for yield elsewhere—and that means pouring money into stocks. Traders who want to front-run this action are buying up European stocks today with the intention of selling to those yield-chasers tomorrow.
2. European Bonds
While European stocks rose, European bond yields were mostly flat for the day, a sharp reversal of recent trends where yields have fallen by as much as 10.8% (Portugal) in the last month. Yields have fallen in every major European country, with the lowest declines in Britain. That declining yield has now stopped with the QE policy, and yields may begin to rise.
This seems counterintuitive, but is identical to what we have seen in the U.S. When Central Banks buy asset-backed securities, bond yields fall. In the U.S., many expected bond yields to rise when the Federal Reserve was buying bonds through its QE program. The idea made intuitive sense: the Fed was inserting artificial demand into the market, while supply remained constant. This would raise prices.
Except it didn’t. Instead, people looked to sell bonds to the Federal Reserve and use the proceeds for riskier assets, which is what the QE program was designed to do.
If this same pattern happens in Europe, we could see European bond prices fall further as sellers look to offload those bonds to the ECB and chase higher yields elsewhere in the stock market. This would be bad for European bonds and bond funds.
3. U.S. Stocks
At its core, asset-purchasing programs by central banks are designed to inject more money into the economy and encourage the speed with which money changes hands (known as money velocity) to increase.
While this activity in Europe is likely to drive European stocks higher, it could also buoy U.S. stocks because European investors can buy U.S. assets and, in any case, U.S. growth remains strong and risks remain relatively low, a combination that entices investment. Since capital can cross boarders relatively freely between the EU and the United States, it’s unsurprising that many traders would expect an ECB stimulus program to benefit U.S. stocks.
Thus, unsurprisingly, the S&P 500 is up nearly half a percent in early morning trading as it leaves 2000 in the dust.
4. U.S. Bonds
U.S. Treasuries are best thought as having two purposes. On the one hand, they are U.S. bonds that provide a storage of wealth for Americans seeking a modest but risk-free return on their savings. On the other hand, they are a store of wealth for the broader global community in times of panic and uncertainty.
Because of this dual function, U.S. Treasuries will react to global events much more than some other government bonds. Because the pool of capital from global investors seeking the U.S. Treasury market is substantially larger than U.S. individual investors, changes to the global economic landscape will have a deep impact on Treasuries.
For this reason, the development of a European QE program is causing a slightly different impact to U.S. Treasuries than we’ve seen for European bonds. Both 10-year and 30-year U.S. Treasuries are seeing falling yields, but 2-year and 5-year Treasuries are suddenly seeing rising yields, as are short-term Treasuries.
This means the market is changing the yield curve to adjust for changing expectations to global growth and demand for a risk-free store of wealth. In the short-term, lower risk and bigger gains from places like the European stock market are causing prices to fall and yields to rise. In the medium-term, improving growth will mean stronger inflation, causing the yields there to rise. But the long term remains uncertain, keeping the far end of the yield curve low.
Conclusion
There are a number of strategies that traders can take in light of the new macroeconomic environment. One important thing all traders should do is to study history and look at how QE in the United States changed markets throughout 2009 to 2013.
Equally important, this development demonstrates the unavoidable need to understand macroeconomic as well as microeconomic indicators when allocating assets to portfolios. It is not merely enough to invest in high value underpriced assets these days; there are too few of them and much larger returns are available from a more top-down strategy.
This means analysts must go far beyond the accounting fundamentals of companies and look as well to the more esoteric relationships that exist between capital flows, bond yields, and stock markets before making acting.