The Federal Reserve looks set to start winding up its quantitative easing (QE) programme later this year. Meanwhile, there is little evidence as yet that the new governor of the Bank of England, Mark Carney, will crank up the printing presses again. So although the Japanese may still have their foot firmly on the monetary accelerator, it looks as if the markets are going to have to get used to a world where central banks are not constantly throwing billions in freshly minted bank notes at them. That’s why bond yields have started to spike up, gold has been hammered, and equity markets have started to plunge in value. The days of easy money look to be over.
But hold on. The markets are missing a very obvious point. If the Fed does end its QE programme, the European Central Bank (ECB) will have no choice but to start one of its own – or else watch the single currency collapse. Why? Because the eurozone can’t afford higher bond yields. That means the QE party can go on for a lot longer yet – except it will be Europe driving it rather than America.
There were reports in the German papers last week that the ECB was putting together plans for its own version of QE, buying bonds from each of the 17 member states in the eurozone according to their percentage of its GDP. The ECB swiftly denied the stories – but then it would. A QE blitz from the ECB is, in fact, inevitable. Here’s why.
The Fed has already signalled that its QE programme should come to an end later this year and it is not hard to dispute its reasoning. The US economy is growing at a reasonable rate again – in the latest quarter at an annualised 1.8%. Jobs are being created. The housing market has started to revive. The banks are back in reasonably healthy shape. Cheap shale gas is reviving manufacturing industry. Against that backdrop, holding interest rates at near-zero should be enough to keep the economy moving forward: printing money looks like overkill.
The result, however, has been a sharp rise in bond yields as the markets anticipate a return to normal rates and start selling. For America, that is fine. The Fed clearly calculates that the economy can afford slightly higher yields. And if it turns out to be wrong, it can always turn the taps back on to send yields back down.
But this all presents a big problem for the rest of the world – and crucially for the eurozone. American bond yields set the benchmark for the rest of the world. When US yields go up, they go up everywhere else as well. That process has already started. Italy’s bond yields are up by 0.7% since 1 May, and Spanish yields by a similar amount. France’s are up by 0.6%, and even supposedly safe-haven German bonds have seen a 0.5% rise. From low levels, those are big increases.
For the peripheral eurozone countries, that will be unaffordable. When rates in Italy and Spain broke through the 6% barrier last year, the euro came close to collapse. That isn’t really a problem for the Fed. It might well be worried by the impact of rising yields on the rest of the world – but at the end of the day, its task is to take care of the US economy, not the eurozone. But it is a big problem for the ECB.
Rising bond yields pose two dangers for the single currency. First, the continent is already locked into what is politely called a recession, but looks more and more like a full-blown depression. Output has now been declining for six straight quarters, and you need to be very optimistic to see it growing anytime soon. Unemployment is still rising fast and stands at 12.1% across the eurozone, a record level. In Spain it is 26.9% and in Italy 12.2%, an all-time record for that country. When you are already in recession, rising interest rates are a disaster.
Next, all the peripheral nations are stuck in a debt trap. Italy already spends more than 5% of GDP servicing government debt, and its economy is shrinking at an annualised rate of 1.5%. You don’t need to know very much about economics to work out that a big jump in bond yields will bankrupt countries such as Italy and Spain, and perhaps France as well.
The Fed’s programme was aimed at reviving the American economy. But it was also keeping the eurozone on life support by keeping bond yields very low and flooding the banking system with cash, some of which found its way into European debt markets. Now that it is being withdrawn, it will not be long before Europe is back in real trouble.
So what can the ECB do? Print money. True, that is not part of its mandate – the treaties that established the euro supposedly prevent the central bank from directly financing governments. And the stern monetary purists at the Bundesbank will no doubt fight it every step of the way. But what choice does it have?
If peripheral bond yields start to rise back towards the 6%-plus level, that spells bankruptcy for half the continent, and the recession is growing worse – it can’t sit by and do nothing. Offered a stark choice between launching its own QE and the currency collapsing, it will start printing.
Investors can, therefore, relax. The Fed may end the QE party that has kept the markets buoyant for the three years – but the ECB will have to step in and flood the market with freshly minted euros.