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Lessons from QE in four charts | 23rd February 2015

Why nothing should be taken for granted  |  March 2015 marks the start of Quantitative Easing (QE) in Europe. The much anticipated programme will inject €1.1tn into the eurozone’s coffers up to September 2016 at a rate of €60bn per month from next month. The European Central Bank will be purchasing national government bonds from member states and, in so doing, it will have become the “lender of last resort” in Europe at last ceding to demands that it provides a backstop to Europe’s fragile sovereign nations in the wake of the financial crisis.

While this has created an uneasy truce between markets and Europe, there is still a long way to go. With QE, systemic risk from sovereign default is avoided and the immediate impact has been to boost equity markets and weaken the value of the euro. Theoretically, this should boost confidence and exports. However, the volatility in markets at present is a product of the broader uncertainty around the effectiveness of QE. Markets need to be convinced that it was the right strategy in the first place, not least because of the broader uncertainties around European geopolitics at present, and are in a mood to test European policy makers in any way they can.

One of the principles of QE is that it reduces the value of the currency and thereby supports real economic growth through exports. Here are the lessons from that trade perspective in four charts:

 

Chart 1  |  US QE – market correction overdue

 

2015-02-23_lessonsFromQE_fig01

 

Figure 1  |  Monthly Value of US exports (USDbn) versus S&P 500, last price monthly
Source  |  DeltaMetrics 2015, Bloomberg

 

The chart shows the close correlation between monthly movements in trade and the S&P 500 at 0.715. Each horizontal line shows the start of a QE programme: December 2008, November 2010 and latterly September 2012. US exports during that time have grown modestly, while the S&P 500 has increased in value substantially faster than its pre-crisis rates, particularly since QE3 in 2012. It appears that one effect of QE has been to worsen the disconnect between asset values and the real economy up to the start of this year.

 

Chart 2  |  Abenomics and the paradox of the yen

 

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Figure 2  |  Monthly value of Japanese exports versus JPY per USD spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

Japan’s relationship with QE has been a long one and has produced a bizarre result: except for the period between October 2004 and May 2007, the relationship between the strength of the yen and exports has been the reverse of what would be expected. As the value of the yen strengthened between June 2001 and October 2004, exports increased. Similarly, as the value of the yen decreased shortly before the implementation of Abenomics in 2012 through to Shinzo Abe’s final asset purchases in October 2014, export trade actually fell. This is a lesson for the developed world economies: exports are currency inelastic and therefore depreciation is unlikely to have much impact on export-led growth.

 

Chart 3  |  UK QE and the export mystery

 

The purpose of UK QE was arguably to protect against systemic risk and loosen up the supply of credit in the banking system to enable bank-to-bank lending. It did not have as its primary focus either exports or real growth. However, as the rest of the world started to pull out of the downturn in the wake of the financial crisis, the question of why sterling had depreciated so much without any impact on exports took on renewed importance. The Conservatives, elected in 2010, set export-led growth as its target and set a goal to double UK exports between 2010 and 2020 to a value of £1 trillion.

 

2015-02-23_lessonsFromQE_fig03

 

Figure 3  |  Monthly value of UK exports (USDbn) vs EURGBP spot (value of 1 euro in sterling), June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

UK QE started in September 2009 and was boosted further in October and November 2009. In October 2011 an additional £75bn in QE was announced followed by £50bn each in February and July 2012. Rather than causing the value of sterling to drop, the immediate market reaction was for it to strengthen. Interestingly, the terms of trade are negatively correlated with the value of sterling at -0.754. In other words, exports will grow in value in relation to imports as the value of the currency depreciates. This is exactly as it should be. Yet the facts demonstrate a very weak correlation (0.466) between the value of sterling and exports. QE has strengthened rather than weakened sterling, as in the US, especially against the euro but even so, sterling has not returned to its levels against the euro of 2001 and has therefore depreciated over the whole period, as have exports.

 

Chart 4  |  QE in Europe – a combination of both?

 

Previous trade views have expressed scepticism at the impact on trade of any reduction in the value of the euro. Like Japan, the eurozone’s trade is highly currency inelastic and, as a result, the depreciation of the euro is unlikely substantially to increase exports and therefore provide a much-needed boost to growth.

 

2015-02-23_lessonsFromQE_fig04

 

Figure 4  |  Monthly value of eurozone exports (USDbn) vs Dax Index, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg

 

However, it is likely that the value of European stock markets could increase substantially. The Dax has reached all-time highs since QE was announced and this creates as substantial a disconnect between economic fundamentals and equities in Europe as there has been in the US and the UK. But this QE-induced asset boost, unlike in the US, comes without an accompanying boost to the real economy in the form of infrastructure spending. Instead, it may well come with restrictions on real growth if sovereign responsibility is tied to austerity rather than structural reform and long-term growth.

Policy makers in Europe now have to ask which lessons they want to learn, and from which chart.