What can ECB easing do for you?

The European Central Bank in Frankfurt

The European Central Bank in Frankfurt

Mario Draghi has been warming up to the prospect of quantitative easing (QE) at the ECB as growth and inflation remain stubbornly low in the EU. While it is far from certain that the ECB will begin large-scale easing, this course of action would undoubtedly create opportunities for investors in the Euro market.

On 6 March 2009, the S&P500 hit its lowest point in the financial crisis. Just months earlier, in December of 2008, the Federal Reserve had begun buying up securities on the open market. As the economic recovery dragged on, asset purchases continued and the stock market rose. Today, the S&P500 has recovered well over 150% and QE is winding down steadily.

I don’t want to get into a debate about QE. Regardless of the extent to which it is helpful or harmful to markets in the long run, it is clear that QE buoys asset prices. This can be observed pretty easily by comparing the historical price of the S&P 500 to the Fed’s balance sheet. This comparison is nothing new, but it is quite timely since history does repeat itself.

SPXFedBSFedSPXScatter

The coefficient of correlation for these two data series is an exceedingly high 0.93. Furthermore, standard deviation is nearly the same as a fraction of each mean, at 17.64% of the mean for the S&P500 and 17.39% of the mean for the Fed balance sheet. This correlation is absent in the pre-QE data (the coefficient drops below 0.5).

If the ECB undertakes QE, this would almost guarantee a medium-term surge in European equity markets. Mario Draghi has now expressed willingness on behalf of the entire central bank’s board to take action if growth and inflation remain subdued. This would present a very favourable scenario for investors.