Expectations are building that the European Central Bank (ECB) may consider quantitative easing (QE) to stimulate the economy, but research house Capital Economics says it might not be the panacea that investors are hoping for.
Comments from ECB President Mario Draghi following the central bank's April policy meeting caught investors off guard. Draghi said "The (ECB's) Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation."
Some investors interpreted "unconventional instruments" as a signal the ECB may consider QE. Unlike the Federal Reserve, the ECB avoided using QE following the 2008 financial crisis, opting instead to boost growth by lowering interest rates and providing banks with unlimited liquidity.
"Of course, the mere announcement of any form of QE could have the desired impact across the board, as it would mark a break from the past and signal the willingness to do more," said Capital Economics' chief economist Julian Jessop. "But the options are now being so widely discussed that it is difficult to believe that some action is not already priced in."
Jessop added that it was hard to see an outcome that pleases all investors - including those anticipating a sharp decline in the euro as well as further large gains both for bonds and equities.
"We do not expect it to be a game-changer for the economy, and what happens on the other side of the Atlantic may ultimately prove much more important for the markets," Jessop said.
Three potential routes to QE
Amid hopes that the ECB will undertake a move to stimulate the economy that will revive sluggish growth and low inflation levels, while simultaneously easing the euro's stubborn strength and boosting equity and bond prices, Capital Economics said there are potential routes it could take if easing takes on the form of QE.
"If the main concern is that the weakness of the banking sector is holding back economic growth, it would make sense to focus additional purchases on private sector assets," said Jessop.
This option, the economist said, would have the largest positive impact on the euro zone equity and corporate debt prices. However, it could have the undesirable impact of strengthening the euro as the relative strength of the region's riskier financial assets increase, which would be negative for core government debt.
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A second option would involve the ECB specifically targeting the risk of deflation by boosting the money supply. This could prompt the ECB to focus on the purchase of government bonds.
However, this could have the adverse effect of strengthening the euro if it undermines the fiscal discipline of the Southern European countries where yields have already fallen to levels hard to justify in terms of the outlook for public finances, Jessop pointed out.
The third scenario would involve the purchases of higher-rated German or French bonds, which Jessop said might go furthest in weakening the euro. But the impact could be limited as yields on these instruments are already very low as investors have priced in the risk of deflation.
Capital Economics expects further ECB easing to contribute to a slight weakening of the euro to $1.30 by year-end and additional outperformance by both European equities and bonds relative to their U.S. counterparts. The euro traded at around $1.3816 by mid-morning trade in Asia on Wednesday.
Investors will listen closely to a keynote speech from ECB President Mario Draghi in Amsterdam on Thursday, as they look for any signs on what steps the central bank may take.