LONDON: The European Central Bank has talked up the chances of launching a bond-buying programme to ward off deflation and having led markets down that path there could be a serious adverse reaction if it does not follow through.

ECB President Mario Draghi pledged on Aug. 7 to use all necessary means to avoid deflation, including “quantitative easing” if necessary. He upped the ante at a US Federal Reserve symposium in Jackson Hole on Aug. 22 by insisting “all the available instruments” would be used to preserve stability.

Markets needed no more invitation to start pricing in QE, no matter how difficult it remains for other ECB policymakers to swallow.

Long-term borrowing rates for euro zone governments from Germany to the “periphery” in Spain tumbled to new record lows and the euro currency shed almost 2 per cent against the dollar.

Ten-year German bond yields shed 26 basis points in August, the biggest monthly fall since January, and 30-year yields lost 31 bp, the biggest loss since May 2012. Equivalent Spanish yields dropped half a percentage point.

If the ECB does not meet market expectations, government bond yields could spike in countries like Italy, which is already back in recession, and fellow high-debtor Spain.

Deutsche Bank estimates bond investors have now factored in a 50-70pc probability of some “QE-infinity type” programme from the ECB.

A Reuters poll last week showed market economists saw a 75pc chance of a QE programme involving the purchases of asset-backed securities by March next year, and a 40pc chance of a sovereign bond-buying scheme.

“If the economy stays at it is and the ECB does nothing, there would be some problems on the sovereign front, especially the periphery,” said Luca Jellinek, head of rates strategy at Credit Agricole in London.

Analysis of other money-printing bouts around the world over the past six years shows the success of QE in reviving the real economy pivots on the bond markets cutting credit costs and that tends to happen before money printing formally gets underway.

This was certainly true of action from the Fed, Bank of England and Bank of Japan as investors move to price in the stimulus as soon as it was mooted by policymakers.

Published in Dawn, September 2nd , 2014