Hangover threat for eurozone QE party

Was this the week the financial market fizz went out of eurozone quantitative easing?

The European Central Bank's January announcement of a €60bn-a-month asset purchase programme sent share prices soaring and the euro tumbling. Government bond prices leapt on heavy ECB buying. Many bond yields, which move inversely with prices, fell into unexplored negative territory.

Suddenly, such trends have gone into reverse. Eurozone equities in April notched up their first monthly loss of the year. German 10-year Bund yields, which had been flirting near negative territory, this week climbed more than 20 basis points to 0.37 per cent - an unusually large jump. The euro rose 4 per cent to $1.12 against the dollar. It seemed Mario Draghi, ECB president, may have lost his magic touch.

Reassuringly for the ECB, analysts and market experts are not yet calling the end of QE rallies. Instead, a host of technical factors were blamed for this week's upsets, including overhyped trades and market distortions. The bad news is that the volatility could be a harbinger of bigger traumas to come. What happened "is very telling of what investors will have to live through in the coming two or three years", warns Pascal Duval, European chief executive at Russell Investments.

The easiest explanation to dismiss is that markets reacted because QE had served its purpose in pumping up economic growth. Eurozone inflation data this week suggested Mr Draghi had averted a deflationary slump - which, at least according to economic textbooks, might have pushed bond yields and the euro higher.

But the euro's rise - which will hit exporters' prospects - was triggered largely by much weaker than expected first-quarter US economic growth figures. Eurozone share price falls also fitted with a gloomier global economic outlook, especially with Chinese growth slowing, and expectations about future eurozone inflation rates remain modest.

"Some data corroborated the view that there is a rubber ball bounce in the European economy but it is a bit fanciful to suggest we saw a big change in perceptions," says George Magnus, economic consultant and former chief economist at UBS.

A more obvious explanation is that after such strong moves in the first part of the year, corrections were overdue. "Like all parties, you have lulls. It is fairly typical for markets to discount everything rapidly and upfront - and then fundamentals have to catch up," says Andrew Parry, head of equities at Hermes Investment Management. "People bought the weak euro story and simply extrapolated it too far. We have to have a summer of consolidation."

"A lot of investors are willing to take profits after a good run," adds Andrew Milligan, head of global strategy at Standard Life Investments. "We should not underestimate that these are sharp movements in thin markets right at the end of the month."

Eurozone government bond prices have also largely reflected supply pressures - Bund yields, in particular, were driven lower because the ECB is buying bonds while Berlin's fiscal prudence means net issuance of German debt is negative. But Laurence Mutkin, global head of rates strategy at BNP Paribas, points out that net supply of eurozone government bonds will turn positive, temporarily, in May. "These dynamics are likely to push yields higher in the near term, before reversing in the summer," he writes in a note.

Traders, meanwhile, complained positions in fixed income markets had become "crowded". Because everyone was assuming prices would go in one direction, a small change in sentiment resulted in abrupt moves. Others blamed regulatory changes, which have made it more expensive for banks to "make markets" by matching buyers and sellers - at a time when central bank actions that have pushed interest rates down to historic lows were forcing asset managers and pension funds to invest in riskier assets.

"What we could have seen was an hors d'oeuvre for what will happen when there is something that really frightens markets," says Mr Magnus. "If there is a bigger problem at some point, there will be a lot of looking in the mirror to be done."

Even if this week's moves were largely technical, especially in fixed income markets, they still could get worse. "The beginnings of the big bear market could start with a correction and then only later turn into something more serious," warns Matt King, credit strategist at Citigroup. Nevertheless, he still thinks the best explanation is that they were a less worrying "reversal and flushing out of positions".

The reversals in equity, bond and foreign exchange markets were modest compared with the previous trend. "Put in the context of the bigger picture of what we have seen year-to-date, we don't view them as extraordinary," says Mr Duval at Russell Investments.

The FTSE Eurofirst 300 share index is still 15 per cent higher than at the start of the year, the euro is 7 per cent lower against the dollar, and German Bund yields are down almost 20 basis points. For some investors, this week's dips could provide buying opportunities. On an optimistic view, they might even help avert a worse hangover at a later date, after all the fizz at the start of the year.

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