The ECB press releases are usually boring as little information is provided and anything of importance is left to President Draghi to expound on at his press conference 45 minutes later. Tomorrow OUGHT to be different because Draghi put his thoughts out in a speech on November 21, in which he mentioned that the ECB could expand its balance sheet by a TRILLION EUROS. Draghi’s November speech resulted in the euro dropping over 1 percent and making its lowest close of the year on that day.
Yesterday and today the euro finally made a lower close as the market anticipates that the ECB will offer up a genuine QE program rather than just mere jawboning from Draghi. QE can take various forms:
- The ECB can buy sovereign debt but this runs into concerns from the German Constitutional Court that the ECB is in possible violation of EU treaties;
- The ECB can mimic the Bank of Japan (BOJ) and move to buy REITs and ETFs, which are not public debt but issues of private sector investment vehicles;
- The ECB can buy a multitude of various assets from corporate bonds to Draghi’s beloved asset-backed securities (ABS) and even GOLD bullion in an effort to flood the banking system with liquidity. Draghi loves the idea of ABS as it is private in nature and possibly the lowest grade of paper as the European banks relieve themselves of non-performing loans–unclogging the credit channels. Remember that Europe is much more dependent on its banks for credit than the U.S.
- If President Draghi wishes to upset Treasury Secretary Lew and insure a lower EURO, the ECB can announce a massive buying program of U.S. Treasuries, which would be buying public debt but not in violation of EU treaties.
These are all possible strategies to will provide for a genuine QE program. They will also circumvent BUNDESBANK concerns about the ECB undermining the European financial system by bailing out sovereign nation-states and merely monetizing domestic debt. The recent rally in the DAX–since November 21–and the strong performance of peripheral sovereign debt (particularly Italy and Spain) signals that market expectations for a firm commitment for quantitative easing is very high. IF DRAGHI DISAPPOINTS THE RESULT WILL BE A FALL IN EQUITY MARKETS AND A RALLY IN THE EURO CURRENCY. GOLD WILL ALSO FALL BUT BE READY WITH SUPPORT LEVELS AS THE MARKET WILL PERCEIVE THAT FINANCIAL RISK WILL BE ELEVATED DUE TO EUROPEAN INTRANSIGENCE. If the ECB policy remains unchanged the BUND will rally against all European debt. Doing nothing will not be a COOL HAND.
***The Bank Of Canada and the Reserve Bank of Australia both kept their interest rate and overall monetary policy unchanged–as expected. The Canadians noted the strength of the U.S. economy as providing some hope but the BOC remains concerned about the negative impact from falling energy prices. The Australians are trying to keep the Aussie dollar down to hope minimize the impact from falling global commodity prices. Seems as if everyone is waiting for President Draghi to deliver.
***The Financial Times has a very strong article on the impact of QE by one of the two credit analysts that I hold in high esteem. Manmohan Singh, Senior Economist at the IMF wrote a piece, “How QE Can Jam the Financial Plumbing,” and discusses that central banks clog the financial plumbing by purchasing high-grade collateral and removing it from the financial system. My other favorite credit plumber, James Aitken, has long taught me about the need for high quality collateral in the repo market. When the FED and others extract HQLA from the markets via QE, less worthy borrowers are forced to pledge lower grade paper and thus pay a higher price for borrowing or may not be able to borrow at all.
In anticipation of the ECB embarking on this type of QE program Mr.Singh notes: “The ECB faces other challenges, however. Some of the best eurozone collateral is at the Swiss National Bank, as its balance sheet expanded significantly after the Swiss franc was pegged to the Euro in September 2011. This has reduced good collateral circulation in the eurozone, providing lessons for the ECB as it considers a possible QE. More generally, the ECB, as does the Fed, has to consider financial plumbing.” The burden on Draghi to craft the correct policy is great. Ok, how many syllables, Mario?