Key Points

Yesterday the European Central Bank (ECB) announced an historic stimulus package for the Euro Zone. Here are the key points:

• The ECB is going to create an enormous pile of new money and use it to buy Euro Area Government bonds on secondary markets. This is known as Quantitative Easing (QE)
• The total planned stimulus will amount to over €1 trillion by September 2016
• This represents a considerably bigger package than markets had expected
• In addition, the ECB has made an open ended commitment – it will keep printing money until the problems are solved

Background

While Ireland’s economy has been performing well, the Eurozone as a whole has been floundering.  In particular, it has two main problems:

• Sluggish Growth: This is partly because the European banking system is perceived to be rationing credit to the productive economy
• Deflation: This is problematic for two reasons. Firstly, if people expect goods to become cheaper, they continuously put off spending. This ultimately leads to a downward spiral. Secondly, if you have lots of overhanging debt – as many Eurozone countries including Ireland do – then inflation is a good thing because this erodes the value of the money you have to pay back.  Conversely deflation creates a heavier debt burden.

How Will (QE) Fix These Problems?

• Better Exchange Rate: If you create more of anything you devalue it. By creating 1 trillion additional Euros, the ECB will cause the Euro currency to weaken (indeed this is already happening).  This will make Euro Area exports cheaper to non-Euro customers, and will drive economic growth through exports.  Ireland will benefit most, as much of our trade is with the non-Euro UK and US.
• Reduced Interest Rates: Although interest rates are already very low, QE will reduce them further.  In looking to buy so many Government bonds at once, the ECB will drive up the price of these bonds.  Given that they pay a fixed annual return, this means that the yield on Government bonds will fall.   This will make it cheaper for Governments to raise new finance in the bond markets.
• More Credit: The ECB will mainly be buying these bonds from banks and financial institutions.  While the banks will make a profit on the sale of their bonds to the ECB, this leaves them with a dilemma;  What do they do with the cash received, particularly as interest rates have been driven effectively to zero?  The ECB hopes that they will decide to put this cash to work by lending it into the productive economy for a higher return.  This should lead to greater investment by companies in plant and equipment, more jobs etc.
• Inflation: While a weak Euro makes our exports cheaper for non-Euro customers, it makes our imports become more expensive.  This, combined with the improved growth generated by QE, should lead to a welcome return of higher inflation over time.

What does this mean for the property market?

Commercial

Government bonds represent the safest asset you can invest in and hence they pay the lowest return.  All other assets (equities, commercial property etc.) have to pay a higher return to attract investors given that they are inherently more risky. Assuming that the risk premium for investing in commercial property remains constant, then lower bond rates will feed through to lower commercial property yields as follows; First, bond yields fall due to QE. This causes investors to flood into riskier assets in search of a better return.  In turn this pushes up commercial property prices and compresses the yield.   The process only stops when the yield on commercial property is pushed down to a normalised premium (‘spread’) over bond rates.  

Residential

The impacts here will be more marginal.  The overall improvement in the economy should strengthen housing demand.  And, as the banks have more cash on their balance sheets following the sale of their bonds to the ECB, they should be more willing to give mortgages. However, this tendency is obviously limited by prudential lending practices (which may shortly be strengthened further by the Central Bank).  The weaker exchange rate may see a few more US and UK buyers particularly at the upper end of the market.

Is QE Going to Work?

Based on the US and UK experience of QE – the answer is probably yes.  However, some commentators have pointed out a few potential pitfalls:

• Banks may not pass on cash to businesses and households: Some argue that weak credit flows don’t reflect an unwillingness of banks to lend but rather a lack of demand for credit as businesses and households try to de-lever following a deep recession. So, rather than stimulating activity by flooding the real economy with credit, the banks could be left with redundant cash on their balance sheets.
• Lending to unproductive sectors: Alternatively, rather than going into the productive economy, lending may be diverted into geared property and equity investments.  Some argue that this has happened with QE in the US and it has only benefited the most wealthy.
• Moral hazard: Commentators in some European countires have argued that if financial institutions sell their bonds to the ECB, they may then seek to quickly replace them with newly issued Government bonds. With such liquidity available, some people are concerned that Governments might take the soft option and continue running up big deficits rather than buckling down and reforming their public finances.