Date
17 December 2017
The ECB could work through various asset-buying programs over the next year or so, taking the place of the US Federal Reserve. Photo: Bloomberg
The ECB could work through various asset-buying programs over the next year or so, taking the place of the US Federal Reserve. Photo: Bloomberg

Europe takes the QE baton

If the wide, wide world of investing doesn’t seem a little strange to you these days, it can only be because you’re not paying attention. If you’re paying attention, strange really isn’t the word you’re probably using in your day-to-day investing conversations; it may be more like weird or bizarre.

The yield on French short-term bonds went negative this week. If you bought a short-term French bill, you actually paid for the privilege of holding it. And then Friday, as if to compound the hilarity, Irish short-term bond yields went negative. Specifically, roughly three years ago Irish two-year bonds yielded 23.5 percent. Today they yield -0.004 percent! The Spanish sold 50-year bonds at 4 percent this week.

We might be able to lay the immediate, proximate cause of the bizarreness at the feet of ECB President Mario Draghi, who once again went all in last Monday for his fellow teammates in euroland. He gave them another round of rate cuts and the promise of more monetary easing, thus allowing them to once again dodge the responsibility of managing their own economies.

The realist in me scratches my already well-scratched head and wonders exactly what sort of business is going to get all exuberant now that the main European Central Bank lending rate has dropped to 0.05 percent from an already negligible 0.15 percent. Wow, that should make a lot of deals look better on paper.

We should note that lowering an already ridiculously low lending rate was not actually Signor Draghi’s goal. This week we’ll look at what is happening across the pond in Europe, where the above-mentioned negative rates are only one ingredient in a big pot of Bizarro soup. And we’ll think about what it means for the US Federal Reserve to be so close to the end of its quantitative easing, even as the ECB takes the baton to add €1 trillion to the world’s liquidity. And meanwhile, Japan just keeps plugging away.

First, let’s look at what Mario Draghi is faced with. He finds himself in an environment of low inflation, and expectations for inflation going forward are even lower. Note that inflation expectations for the entire euro area are well below 1 percent for the next two years – notwithstanding the commitment of the European Central Bank to bring back inflation.

As I noted at the beginning, ECB policy has already reached the zero bound. In fact the overnight rate is negative, making cash truly trash if it is deposited with the ECB.

With inflation so low and a desperate scramble for yield going on in Europe, rates for 10-year sovereign debt have plummeted. It is not that Italy or Spain or Greece or Ireland or France is that much less risky than it was five years ago.

Note that banks can get deposits for essentially nothing. They can lever those deposits up (30 or 40 times), and the regulators make them reserve no capital against investments made in sovereign debt. Even after their experience with Greek debt, they essentially claim that there is no risk in sovereign debt.

If your bank’s profits are being squeezed and it’s hard to find places to put money to work in the business sector, then the only game in town is to buy sovereign debt, which is what banks are doing. Which, of course, pushes down rates. Low interest rates in Europe are as much a result of regulatory policy as of monetary policy.

The yen hit a six-year low this week (over 105 to the dollar), creating even more of a problem for Germany and other European exporters to Asia. Germany’s exports to the BRICS except China are down significantly over the past few years, partially due to competition from Japan as the yen has dropped against the euro.

The yen-versus-euro problem is exacerbated by the remarkable appetite of Japanese investors for French bonds. This has been going on for over a year. In May and June of this year alone, Japanese investors bought US$29.3 billion worth of French notes maturing at one year or more. Note that even with minimal yields, the Japanese investors are up because of the currency play.

Japanese analysts say that Japanese investors are hesitant to take the risks on the higher-yielding Italian and Spanish bonds, but for some reason they see almost no risk in French bonds. This behavior, of course, helps to drive down the price of the yen relative to the euro.

It is probably only a coincidence that just as the Fed ends QE, Europe will begin its own QE program. Note that the ECB has reduced its balance sheet by over US$1 trillion in the past few years (to the chagrin of much of European leadership). There is now “room” for the ECB to work through various asset-buying programs to increase its balance sheet by at least another trillion over the next year or so, taking the place of the Federal Reserve. Draghi intends to do so.

Risk-takers should take note. European earnings per share are significantly lower than those of any other developed economy. Indeed, while much of the rest of the world has seen earnings rise since the market bottom in 2009, the euro area has been roughly flat.

Both the US and Japanese stock markets took off when their respective central banks began QE programs. Will the same happen in Europe? QE in Europe will have a little bit different flavor than the straight-out bond buying of Japan or the US, but they will still be pushing money into the system. With yields at all-time lows, European investors may start looking at their own stock markets. Just saying.

Draghi also knows there is really no way to escape his current conundrum without reigniting European growth. One of the textbook ways to achieve easy growth is through currency devaluation; and as we wrote in Code Red, the ECB will step up and do what it can to cheapen the euro in competition with Japan.

Just as the world is getting fewer dollars, Draghi is going to flood the world with euros.

Bank of Japan Governor Kuroda has steered the BOJ to where it now owns 20 percent of all outstanding Japanese government debt and is buying 70 percent of all newly issued Japanese bonds. The BOJ hoped that by driving down long-term rates it could encourage Japanese banks to invest and lend more, but bond-hungry regional Japanese banks are still snapping up long-term Japanese bonds, even at 50 basis points of yield.

Given the current environment, the Bank of Japan cannot stop its QE program without creating a spike in yields that the government of Japan could not afford. Hence I think it’s unlikely that Japanese QE will end anytime soon, thus putting further pressure on the yen.

The BOJ is going to continue to buy massive quantities of bonds and erode the value of the yen over time in an effort to get 2 percent inflation.

In a world where populations in developed countries are growing older and are thus more interested in fixed-income securities, yields are going to be challenged for some time. Those planning retirement are going to generally need about twice what would have been suggested only 10 or 15 years ago in order to be able to achieve the same income. Welcome to the world of financial repression, brought to you by your friendly local central bank.

The writer is an author, a commentator and publisher of the Thoughts from the Frontline newsletter.

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RC

A noted financial expert, a New York Times best-selling author, an online commentator, and the publisher of investment newsletter Thoughts from the Frontline

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