Business

The European Central Bank's QE decisions and your portfolio

The Sterling Report

Pamela LEWIS

Sunday, September 24, 2017

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The European Central Bank (ECB) instituted an asset-purchase programme two years ago for government and corporate bonds in the primary market. The programme is widely known as quantitative easing or QE for short.

Its objective is to enhance/foster economic growth, but it also has a secondary objective of increasing inflation, and lowering interest rates. Because of its mandate to inject life into the economy, it has come to be referred to as an “economic stimulus” programme.

In 2015, the programme was used to stabilise European banks which were suffering as a result of the US subprime mortgage crisis. The current state of the European economy is proof that the stimulus has been working. Inflation is at 1.5 per cent (a marked improvement even if it still falls short of the 2 per cent target), 17 consecutive quarters of growth were recorded, and interest rates have been trending down.

But how does quantitative easing work? When the ECB purchases bonds, this tends to have the effect of driving up the price of bonds, and in the process forces yields down.

It would be easy to see that these reduced yields would generally translate to lowered borrowing costs which increases companies' ability to raise money that they can invest, leading to growth for them and a commensurate growth in the economy.

Another positive effect of these ECB activities is an increase in liquidity, which is achieved through the increase in money supply brought about through the bond purchases.

The increased money supply has the effect of creating demand for other assets which in turn puts upward price pressure on other financial assets such as real estate in Germany which some analysts believe may be near a bubble.

When the macro-economic/monetary targets are sufficiently achieved, it may become necessary for the ECB to pull back on the economic measures that have been previously introduced so as not to allow the economy to overheat.

One such means is by the use of “tapering”. Tapering is the process of reducing the number of bonds the ECB purchases from both the government and the private sector.

This is the position where the ECB now finds itself: to make the decision as to the cut-back in purchases. However, at the September sitting, the ECB stated, “We stand ready to increase our asset purchase programme in terms of size and/or duration.” They are expected to announce more details on any possible tapering in the October meeting.

That said, how do these ECB decisions affect the bond investor? Obviously, the investors affected by the ECB decisions would mostly be those who are buying or selling European bonds.

When the ECB is purchasing bonds, it suits the investors to be purchasing at the same time, as the inevitable result is that, going forward, bond prices would be increasing, especially as more investors demand these bonds, but more so because these bonds become scarce because the ECB is purchasing them in such large amounts.

As such, investors would see some increase on their return on investments as prices move upwards.

Since many investors are not involved in the day-to-day market activities, a good idea is to ask one's trusted financial advisor about these bond-purchasing activities.

However, it must be noted that the ECB is now at the opposite end, that is, it is now at the point of making a decision to reduce its bond-purchasing activities (tapering). Should the tapering decision be taken, European bond prices would be expected to fall.

But the ECB will only make this decision if the targets set are met, so it would be a good idea for investors to keep an eye on the ECB's targets. Should the targets be achieved, an investor's next move would be to sell their bonds at the high prices they can now fetch, before the anticipated fall in prices.

But a fall in prices would signal renewed opportunities, so investors could look forward to purchasing bonds at lower prices (and higher yields) during the period of tapering.

In conclusion, the ECB bond-buying programme has given investors a glorious opportunity to make huge returns on their investments, and some investors have already taken advantage of this opportunity and have benefited tremendously.

It is now up to investors to decide their next move, but they must keep abreast of the ECB's activities in order to make sound decisions.

And, as always, investors should never forget to discuss their selling and buying decisions with their trusted advisor.

Pamela Lewis is vice president, Investments and Client Services at Sterling Asset Management Ltd. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm

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