Draghi: Quantitative Teasing “Whatever it takes!” was Draghi’s mantra just a few years ago. He has been promising action for all that time and has basically delivered nothing. As I noted a few weeks ago, he has pushed his “street cred” to the limit. He really has to deliver something at the January 22 ECB meeting, or the markets will simply no longer believe him. If he doesn’t do something significant, I think the euro could rip higher, applying even more deflationary pressure throughout Europe. Draghi is not lacking in the desire to be more like Bernanke and Yellen. The problem is that he must win consensus among the board of governors of the ECB. To do any serious quantitative easing without the approval of Germany and its Bundesbankers would create very serious problems for him in Europe. It now appears that what the ECB will do is compromise. They will go ahead to do QE, but each country will assume responsibility for its own bonds. Under that plan, Germany will not be responsible for French or Italian or Spanish bonds bought by the ECB. The ultimate responsibility will be with the national central banks of the individual countries. This would create a “silo effect” and have long-term implications. To take one example, as noted above, Italy has 133% debt-to-GDP, and its debt is growing at 3 to 4% a year. Now, if the ECB began to purchase Italian debt, the cost of that debt would fall. Since Italy has to refinance (and purchase new) at least 10% of its debt this year with an average cost of well over 3.5%, it could lower its overall interest cost. But given that the country is in deflation and will likely be in its third straight year of recession, deficits will be higher than forecast, and debt-to-GDP will increase. As I have noted on numerous occasions, Japan no longer has a functioning bond market without the Bank of Japan. What happens when Italian debt rises in cost to the point that individuals no longer want to buy that debt and the market essentially becomes the European Central Bank? Crazy? I think not. It won’t happen this year or the next or even for a few years after that; but unless Italy gets its budgetary house in order – something that will be difficult given its huge pension and healthcare obligations and poor demographics, debt-to-GDP of 150% or 160% is possible by the end of the decade. That is the level at which Greece became a problem a few years ago. Now, I understand that all my Italian readers will point out that Italy is not Greece, but they both have to coddle the bond market with a reassurance that those who bought will get paid. And given the track record of Italy over the last century, it is not altogether clear to me that you can approach Italian debt with 100% confidence. I know, it’s different this time; but bond buyers are a fickle lot. You buy government bonds because you want to avoid risk. Draghi is going to have to fight the perception that he is enabling countries to avoid dealing with their imbalances, even as he tries to improve the terms of trade by forcing the euro down. The common wisdom is that now the Germans are fighting against assuming Italian debt by putting it on the books of the ECB. But Will Denyer points out this morning that there is reason to think that the various countries might actually want that debt for a time, until it can indeed be mutualized in some distant future. Writing for GaveKal, he says: The US has just provided a remarkable example of the third option at work. Last year, the US Treasury paid a record amount of interest, roughly US$430bn. But over the same period the Fed remitted almost US$100bn to the Treasury, thanks to a balance sheet bloated by QE operations. If we net out remittances from the Fed, the Treasury’s interest payments fall by almost a quarter. Or, to put it another way, with US$17.6trn in debt outstanding in 2014, this effectively lowered the Treasury’s interest cost by around 50bp. And that is before we factor in any effect on market rates. But what about the eurozone, where many governments are involved? Normally, any profits made by the ECB are pooled and distributed to member countries in proportion to the central bank’s capital subscription weightings, which are based on population and gross domestic product. That means Germany gets the most, then France, and so on... These outflows pay no attention to where the profits came from. In a QE program today, most of the profits are not going to come from German or French bonds, which yield next to nothing. Most are going to come from the smaller peripheral governments that are currently paying more interest on their debt. We don’t need to do any math to figure out that QE done by the ECB would result in a massive transfer of wealth from the periphery to Germany and France. This is true almost regardless of how purchases are apportioned. What would make a big difference is if the ECB made an exception to its normal profit-sharing practices, and said that all profits on Portuguese bonds will go back to the Portuguese government, all profits on Italian bonds go back to the Italian government, and so on…. In this structure, all eurozone governments would benefit from QE, at the expense of anyone holding the currency (just as happened in the US, UK, Japan…). The German government would also benefit from any central bank purchases of its debt, but it will no longer also receive a massive transfer of wealth from the periphery. While everyone is talking about how Germany may demand that credit risk be isolated within each country, that may be a mirage. It may well be the peripheral governments that want the profits from QE to stay within each country – so they can reap all of the regular benefits of currency debasement. What does this mean for markets? However it is structured, QE is likely to weigh on the euro (that is, if the ECB actually debases its currency on a scale that lives up to lofty expectations). A big QE announcement would also probably lift equity prices, at least initially. So what caused the Swiss to act? I think it was in part that they looked at the general weakness of Europe and its seeming inability to pursue reforms or to address its imbalances in any realistic manner. Many Eurozone leaders seem to think the European Central Bank has magic in its vaults and simply hope that the Germans can be persuaded to release some of that growth pixie dust. The Swiss look at their own experience and see the continued growth of debt and unfunded obligations in Europe as a real problem. On top of all the other developments, the European Court of Justice issued a preliminary ruling on Wednesday that allows the ECB to employ quantitative easing. There are rumors that the ECB is going to propose a package that may run as high as €2 trillion – countered by “leaks” that suggest the total will be a fraction of that amount. Frankly, the market has priced in €500 billion already. If Draghi doesn’t deliver a multiple of that, I think we will see a disappointed market. Was the Swiss banking and business community given a heads-up? Were there phone calls from one desk to another? Clearly, there are communication channels. And the timing of the ECJ ruling and the announcement by the SNB the next day is more than suspicious. (Yes, I know it’s a preliminary ruling, but do you really think it will get changed?) I think the SNB looked down the road and saw the euro at parity to the dollar (which is where Draghi and the rest of Europe would like to have it), realized how much they would have to spend and ultimately lose to maintain the euro peg, and decided it simply wasn’t worth the cost. That $70 billion loss could turn into a $150 billion loss before you knew it. Simply removing the peg and taking that much buying off the table will in itself begin to reduce the value of the euro. Will the Swiss begin to move some of their rather large euro holdings to US dollars and other currencies? That move would seem the logical follow-on, and it would push the euro down even farther. In 2002 I said the euro would rise to $1.50 and then fall back to parity. We do seem to be on that journey. This is not, of course, a one-way trip; and I would expect the euro to correct upwards at some point before resuming its downward journey. The interesting question will be, if the ECB starts down the path of QE, at what point will it feel it can stop? Will it depend on an inflation-target number? It doesn’t seem likely that QE can actually deliver inflation in a deleveraging world – and Europe must at some point deleverage. Thus, we could see QE in the Europe for a rather long time. The Eurozone is simply unbalanced, and a monetary policy appropriate for Italy or Spain is not appropriate for Finland or Germany. Unless and until its members create a fiscal union and come up with some formula to mutualize their debt, the Eurozone will remain imbalanced and will become increasingly likely to break up. Ironically, if they fail to pursue QE, there will be a crisis sooner rather than later; but a crisis is precisely what they need in order to address the present imbalances. They are not going to substantially reform their labor and budgetary processes except in the act of crisis resolution. A significant QE package (on the order of €1 trillion or more per year) may be enough to postpone the crisis for at least several years. And perhaps that is all they intend to do, thinking that somehow they can all get a handle on their budgets and that growth will magically ensue in a world where debt has already overwhelmed the markets and governments have grown too large relative to the private sector that is necessary to support those governments. Stir into that mix healthcare and pension obligations that are even larger than those in the United States, and you have a surefire formula for a major crisis at some point in the future. Traders tend to act as if the current trend will never end. For some odd reason, they trust central bankers, when the truth is that central bankers will lie when they feel it is necessary. As Anatole said, they believe they have a license to lie. But one way and another, the current relative quiet in Europe will not hold indefinitely.
Posted on: Tue, 20 Jan 2015 06:41:57 +0000