During the last month markets have adopted the approach of “Don’t Worry Be Happy.” No event increases risk awareness as central banks being perceived as the guardian angel of all global investors, so every possible geopolitical event is merely a fresh buying opportunity. This week brings the ECB rate decision and consensus seems to be that President Draghi has secured a vote in favor of cutting interest rates from 0.25% to 0.15%, a drop of 10 basis points, or, as the talking heads and pundits of pabulum will with great fanfare scream, the ECB has cuts interest rates by 40 PERCENT. Ah, the beauty of small numbers in a zero interest rate environment. I DOUBT THE ECB WILL GO NEGATIVE AT THIS TIME. Why? Negative interest rates by a large central bank will be an experiment that the ECB will not wish to embark on, especially as U.S. money market funds have returned to providing short-term financing for European entities. Going negative may result in money market funds shying away from the uncertainty of negative deposit rates paid by the central bank.
Also, the ECB will be in the dark about just how large the negative rate program will have to be to FORCE European banks to begin using reserves rather than just leaving the reserves with the ECB (or Federal Reserve). President Draghi knows that the issue is not liquidity but rather the fragile nature of bank balance sheets creating a lack of loans to small and medium enterprises (SME). The lack of economic growth makes EU banks fearful about lending additional money to businesses struggling with large debt exposure. This is the reason that President Draghi continues to opine on the importance of energizing the ABS market for the entire EU finance system. Asset-backed securities would allow the banks to offload all types of loans into pools of investment grade bonds which the ECB would buy from the banks, freeing up debt constrained balance sheets. Draghi and others are hopeful that investors would eventually purchase the ABS when economic growth eventually begins to increase.
The problem is that the ECB becomes a BAD BANK and is potentially saddled with a huge pool of non-performing loans. The question just cannot be avoided. Who ultimately guarantees the ECB? The United States does not have the same problem because it is the central bank of a unified fiscal authority and has centralized taxing power and financial authority to backstop the FED. In Europe there is no centralized fiscal authority as every nation is the sovereign over its budget and taxing authority. So who guarantees the ECB said the German voters? Which leads to more questions than answers but the complacent investors are secure in not asking the ultimate question.
1. European elections:The market response to last week’s European Parliamentary votes was perplexing in the lack of volatility. The strong showing by the Front National in France should have provided a caution flag for investors of European debt but the market barely flinched and investors continued to acquire French, Italian and Spanish debt. In my opinion, it is the French government that will provide the greatest pressure on both the ECB and the European Commission to try to weaken the EURO in the hope of generating some new stimulus for the peripheral nations. A weaker euro is no panacea but it may result in a 0.5% increase in GDP if the IMF studies are to have validity.
The end result will be that the German economy will be the major recipient of any depreciation of the euro for it is the Germans who are outperforming most of the world’s economies, even with a 1.37 euro. The French political elite is fearful of the Le Pen victory in the EU elections and will seek to redress their fears by pressuring Brussels. The Maastricht treaty calls for a threshold of 60 percent debt/GDP ratio and a cap of 3 percent government deficits. These are the levels that all EU governments have pledged to achieve but the recent elections will render this discussion moot. And yet the world’s investors bought more Spanish, Italian and French debt. Oh well, C’EST LA VIE.
(If I am correct about the effort to depreciate the EURO, the outcome ought to be that the German DAX becomes the best-performing equity market in the developed world. The economic locomotive of Europe will be firing on all cylinders if the French win the battle for the soul of the euro.
2. Complacency reigns in the U.S. as investors accept that the SPOOs and DOW are the repository of safety and reward. Whatever problems exist for the U.S. financial system the solution is more equity in one’s portfolio. The pundits have suggested for two years that the SPOOs were subject to a sizable correction because volume was not strong enough to support higher prices. In the age of HFT it may be that all investors have to rethink the idea of volume. The extensive use of ETFs and other tools may mean that traditional measures of volume have been altered. There’s no fear of inflation rising in these markets as the FED‘s continued buying of BONDS AND MBS prevents any rise in long-term yields (buy more stock). The FED has assured the markets that it will err on the side of leaving interest rates lower for far longer than previously anticipated.
If the G-7 provides the okay for Europe to depreciate the EURO–as it did with Japan–a stronger DOLLAR will result in the FED delaying a rate increase as a rising dollar will be considered a headwind for the U.S. economy (buy more BONDS). Ah COMPLACENCY WHERE IS THOU STING? Jeremy Stein has retired from the FOMC Board of Governors but is warning about the mispricing of risk because of the FED‘s QE programs should be heeded. Mario Draghi. it’s your turn.