The jury is still out on the efficacy of quantitative easing to spur growth and inflation. The most optimistic supporters of the program would argue that some growth could be attributed to lower financing costs, and market participants would probably agree that, to some degree, U.S. asset prices have been supported by the Federal Reserve buying program. Just think about it. The Federal Reserve’s balance sheet grew to approximately $4.0T from $1.0T since QE1 began. It’s hard to imagine a program of that magnitude having no impact.
Now that the European Central Bank started their own $60B a month QE buying program – with a soft ending date of September 2016 for a total of ~$1.1T in asset purchases – it seems very plausible the same outcomes may occur in the Eurozone. Certain economic and market indicators since Euro QE started are showing signs of life. Equity valuations on the DAX, Euro Stoxx and CAC indices are all up over 16% YTD. The EURO/USD 3-month moving average has fallen to $1.10 (as of 3/26) versus a moving average of $1.32 when the U.S. QE program began five years ago. Eurozone forward looking economic indicators are in positive territory, with PMI at 54.1, up from an average of 50 for the last six months. And the Euro Citi Surprise Index hit a recent high of 53.1 after being in negative territory six months ago. The early results of the Euro QE program look very similar to those of the U.S.
Tying the U.S. and Euro QE program together has been the strong correlation between the two economic regions’ interest rate markets over that last 5 years. Correlation between the 10yr and 5yr USD and Euro curve is 0.72 and 0.52, respectively. This relationship lends support to the idea that U.S. rates have limited upside as long as the Eurozone continues their QE program. Furthermore, as long as the USD remains strong versus the Euro and other currencies, it is very likely U.S. exports will constrain GDP growth and cheap import prices will keep inflation low. The lack of an external growth drivers combined with falling prices for imports may limit the Federal Reserve’s motivation to move off their zero bound interest policy.
The similarities between the U.S. and Eurozone QE programs and the strong relationship between their interest rate environments provides a compelling argument for taking advantage of the steepest part of the yield curve, the 5yr, which is where you will find SNW adding exposure.
Source: Bloomberg and SNWAM Research