We’ve been talking about inflation as being one of the big potential themes for this year.
I’ve mostly been thinking about inflation in connection with the US and the UK.
But there’s one particular area where even a gentle uptick in inflation could have a very significant impact, mainly because it’s taken everyone by surprise.
Europe is bouncing back fast – and that means QE has to end
Back in late 2009 and early 2010, just as everyone was starting to accept – warily – that the acute phase of the financial crisis was most likely to be over, the eurozone crisis followed hot on its heels.
Greece admitted that it had a huge hole in its budget. And over the next few years, the country was in the news non-stop. It was probably the most attention the country had been paid by British newspapers in at least 20-odd years.
The acute phase of the eurozone crisis was only really brought to a halt by European Central Bank (ECB) boss Mario Draghi in July 2012, when he promised to do “whatever it takes” to save the euro. That was partly the result of markets looking as though they would turn their attention to Italy next. Greece was a potential casualty that the eurozone could afford to let go. Italy – not so much.
So Draghi pulled out the stops. That signalled a turning point, because – in effect – it meant the Germans were no longer in charge. Draghi cut rates, and eventually got the go-ahead to do quantitative easing (QE). Since January 2015, the ECB has been buying up government bonds in the eurozone and effectively bailing out the region’s banks by the back door, while at the same time suppressing the euro exchange rate (which has been great for a big exporter like Germany).
And throughout this time, understandably, the sense has been that Europe is in crisis. Sure, Germany is booming, but as for the rest of the region, the sense is that unemployment is high and growth is weak – it’s ugly. If any part of the world has been in danger of sliding back into deflation, or blowing up in a populist mess, or seeing a “Lehman Brothers moment” any day – it’s been Europe.
This mindset has persisted – similarly to the way that the deflation mindset has persisted – despite the fact that it’s clearly no longer true.
The fact is that the eurozone economy saw a very strong growth rebound during 2017. And the latest manufacturing surveys show that activity is at record levels in many countries, and at its strongest region-wide since before the euro launched.
In short, while individual eurozone members still have their problems (Greece has endured the equivalent of the Great Depression, and while it’s now growing, it’s doing so from a very low base – and of course, there’s Italy), the reality is that as a whole, the region is doing OK. In fact, it’s doing pretty well.
So, given that many members of the ECB were a little squeamish about QE in the first place, the pressure is on to look at ending it. For example, reports Bloomberg, the ECB’s Benoît Coeuré said that unless inflation disappoints this year, the QE programme is unlikely to be extended when it ends in September.
And given the strong growth, the steady fall in unemployment, and the rebound in oil prices, it seems unlikely that inflation will disappoint.
That’s all fine, surely? I mean, if the economy is recovering, there’s no reason to keep doing QE, is there?
There’s just one problem. The US has been without QE for a while now, and the yield on the ten-year US Treasury is just above 2.4%. The yield on the ten-year German government bund – which is the rough equivalent of the eurozone “risk-free” rate – currently stands at around 0.4%.
That’s a massive gap – indeed, it’s among the widest “spreads” seen since before the fall of the Berlin Wall. Is that the sort of situation that’s likely to survive rising inflation and falling QE? It seems unlikely, put it that way.
This is the year that QE really ends
So we’ll be keeping a close eye on the German bund yield. But it’s not just about Europe.
Robin Wigglesworth made a good point in yesterday’s Financial Times. The fact is that the relatively calm reaction to the US Federal Reserve’s “tapering” process may have been something of an illusion. Because while the US central bank has been easing up on the money printing, the ECB and the Bank of Japan have still been flooding the market with money.
In fact, Wells Fargo reckons that between them, “central banks have absorbed more than all the bonds issued by G10 governments over the past two years”. But with the money printing drying up across the board, “they will only buy 40% of overall debt issuance”.
That’s quite striking. Indeed, Torsten Slok, Deutsche Bank’s chief international economist, reckons that “the ECB’s exit from bond markets is the single biggest risk facing global markets in 2018”.
Money from the ECB has found its way everywhere – into the US corporate bond market, for example. In effect, 2018 marks the year in which the marginal buyer – global central banks – steps back from the market.
Maybe it won’t get messy. But markets have got used to taking an awful lot of things for granted in recent years – suppressed bond yields, a sense that interest rates can only go down, and the reassurance of a ready, price-insensitive buyer of last resort being present in the market all the time.
That’s set to change this year. And if you think that won’t have any sort of effect on asset markets – well, you’re a lot more optimistic than I am.