Europe’s QE: will it work, what the market thinks?

This week James Mackintosh of the Financial Times wrote that the market reaction to the prospects of QE in Europe suggests that QE will happen but it will not work. Mackintosh’s arguments run along the following lines. In the US quantitative easing worked mostly as a confidence boost. When the Fed started bond purchases the bond yields went up. On a purely demand and supply level of analysis this made no sense. Increased demand should have brought the bonds’ prices up and their yields down. But because QE did work its miracle in the US (i.e. it did boost investor confidence) money flowed into stocks and other assets and bond prices decreased.

In Europe, however, as Mackintosh points out, German bond prices were going up while yields dropped on 27 November to a record low of 0.7%. Mackintosh reasoned that this implies that the market believes there will be QE in the eurozone but it will fail to boost confidence, and therefore the simple demand and supply logic is playing out. Hence German bonds price went up and yield reached lower.

Two things contradict this theory.

First, the short term market reaction is almost certainly driven by traders front running of the asset purchases. Mackintosh did acknowledge this effect and he even mentioned that this also initially happened in the US. What he seemed to have missed is that the traders cannot be equated to the market. Traders react quickly to news of economic significance or to changes in supply and demand. But traders’ moves are not necessarily indicative of the broad market’s perception of the fundamentals that drive the economy. Traders have a short-term outlook. To be sure they do react to the moves by the longer-term minded big institutional investors. But “fundamental” investors’ reaction may be slower than the daily volatility created by traders. The transmission mechanism between the “fundamental” investors and the traders can take some time. Ultimately it is the slower reaction of the big “fundamental” investors that will shift the market and show whether QE worked. At this stage we are yet to see the “fundamental” investors’ reactions. From this perspective it is premature to judge whether the market “believes” that QE will work in Europe. (One of the weird things here is that QE will work if investors believe that it will work. But this is another story to be examined separately.)

Second, Mackintosh only focused on the reaction of the price of yields of German 10-year bonds. On the exact same day, 27 November, when German bond yields were reaching record low, the German DAX index was rising for an 11th day in a row, telling another story – investors’ confidence was on the rise.

The two points above do not clearly point to any conclusion on whether the prospective QE in Europe will inspire market confidence. But they show that it is premature to reliably gauge the market sentiment on QE’s fortunes. We still need to see more data as the events unfold.

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