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Will the ECB follow the Fed? - Outside View by Asad Dossani

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Will the ECB follow the Fed?
Dec 6, 2010

As the European crisis continues, the European Central Bank (ECB) is doing what it can to contain the fallout. Most recently, they have decided to purchase the bonds of peripheral European countries in order to bring down their borrowing costs. They have achieved temporary success as bond yields did fall and the euro did rise.

The Fed's response to the slowdown of the US economy has been quantitative easing. They purchased US government bonds on a large scale to keep yields low, and allow the government to easily finance its deficits. Effectively, this is printing money to finance government expenditure.

Many are expecting the ECB to eventually follow the same route as the Fed. It is already showing signs of this through its bond purchases. However, the have not committed to a full-scale quantitative easing program like the Fed has.

The biggest problem for the peripheral European countries is their rising bond yields. Not only do that have large debts and deficits, but they are also finding it increasingly difficult to borrow money to finance these deficits. The high yields are a signal that the market is pricing in a certain risk of default on these bonds.

Unfortunately, the high bond yields make their future much more uncertain. They may end up needing a bailout or defaulting simply because the market expects this to occur, and their bonds are priced to reflect this. This is where the ECB can come in to prevent this from occurring.

European authorities have three options to deal with the debt problems in the periphery. First, they can continue to bailout countries like they have done with Greece and Ireland. Second, they can allow these countries to restructure their debt, thereby making bondholders suffer the losses. Third, they can embark on a quantitative easing program and buy government bonds on a large scale.

The first option is very unpopular politically. European governments will try as much as possible to prevent future bailouts from occurring. They may find that this is not possible in some cases, but they will certainly try and avoid it.

The second option is probably the best in the long-term, as it puts the losses directly on to those who invested. After all, why should taxpayers pay for investment losses by private investors? Unfortunately this option is unlikely to occur, primarily because the main investors in peripheral European government bonds are German, French, and British banks. They certainly do not want a situation where their banks suffer large losses on these bonds and then need a bailout themselves.

The third option is the one that is least costly, politically speaking. It is not the best way to deal with a debt problem, but it is the easiest way. For this reason, it is quite likely that the ECB will embark on greater bond purchase programs in the future. Therefore, to answer the initial question of the article: Yes, the ECB will end up following the Fed to deal with the debt problems.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

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