Here Comes the (not so) Big Bazooka

Economic analysis by Filipe R. Costa

We are imminently expecting the very big decision from the ECB on asset purchasing. This could to put a stop to the deflationary spiral the Eurozone is in and give a desperately needed boost to growth and employment.

Six years into the financial crisis and Europe has still not fully recovered from it. So many credit enhancing measures, so many debt fixing measures, but so few real improvements have been seen. The ECB will eventually give markets what they’re looking for but will leave a wave of disruption behind it. So much time has elapsed and so much communication has been involved that I believe there is no potential surprise effect possible, other than a negative one which may come from falling short of the huge expectations Draghi has helped to form.

This week is so important for the history of the Eurozone it has been referred to one that will dictate the future of the Union. Tomorrow, investors won’t take their eyes off the markets while they listen to Draghi’s announcement. And during the weekend, European politicians will hold their breath while closely monitoring the results from the Greek general election.

At the end of 2008, everything seemed fine in Europe until a massive wave of disruption ignited, with the mortgage backed securities crisis in the US hitting the region and unearthing years of unsound credit practices and dubious government finances. Since that point, the population, in particular in the Southern part of Europe, has been hit by large fiscal cuts, epic increases in unemployment rates, and of course, by deflation. Six years have passed and the Eurozone GDP is still 1.6% behind what it was in 2008.

But the worst part is what is hidden behind the Eurozone averages: a reality of complete disjoint where each country is ever more dissimilar to its neighbour.

While Germany reverted the slump seen the crisis, growing by 3.6% since 2008, Portugal and Spain are down by 6.6% and 6.2% respectively. Greece is 25.6% worse. These are insurmountable differences that can never been approached with a common monetary policy tailored for the average problem. Draghi has been alerting the necessity of fiscal integration to address such issues, as he very clearly stated in his recent speech at the Finnish Parliament. But European politicians insist on doing nothing while waiting for the ECB to act.

Let’s now pretend the monetary policy is the solution for all European problems and that the big bazooka asset purchase programme will effectively been announced by Draghi.

A large-scale asset purchase is expected to; include government bonds, because otherwise there wouldn’t be enough assets; is expected to drive yields lower; is expected to drive credit higher; is expected to drive asset prices higher; is expected to drive consumption, investment and inflation all higher.

But the evidence shows that banks have not been able to drive all liquidity that has been injected by central banks to investors and consumers. The first problem is the fact consumers are not willing to borrow because of the massive cuts experienced in wages. The second problem is the fact that companies are not willing to invest in new projects at a time the economy is already working much behind its full capacity. The third problem is that banks don’t want to lend money to more risky parties when they are assured by the central bank of a risk free profit by applying all liquidity they have in sovereign bonds from peripheral countries instead.

Now add QE to the above recipe.

The ECB is willing to buy sovereign debt from banks (as it can’t do it directly from governments).

Let’s say you were a bank. You would face two options: 1) sell the sovereign bond and deposit the proceeds at the central bank earning a negative rate (-0.20% on the deposit facility); 2) keep the (now) risk-free bond earning a positive yield for a few years. In my view that choice isn’t difficult and that’s the main reason why I think the ECB will face severe difficulties in seducing banks to sell their asset holdings, at least in the proportion the ECB needs.

In the meantime, while the ECB struggles to achieve the necessary results, a wave of disruption is left in the path. The side effects from central bank action are insurmountable, in particular for those countries with strong links with the Eurozone. The Swiss National Bank (SNB) had no other option than to abandon its peg of the franc to the euro. With the ECB buying assets in a large scale, European yields are expected to decrease, which is expected to lead to a massive capital outflow looking for safety and yield.

The Swiss franc is a serious candidate for the role, which means the SNB would face too much upside pressure on its currency. That already happened in December when capital inflows to the country rose dramatically. In fact, the peg has led to an expansion of the monetary base from 80 billion to 400 billion Swiss francs. As a consequence, credit rose from 145% of GDP to 170% and the price of an apartment has risen by 60% since 2007. In effect, the Swiss have engaged in a kind of forced QE due to its close ties to the Eurozone.

But the SNB is not the only casualty among central banks.

While they gave up, Denmark is struggling to keep its official peg of the krona to the euro at a rate of 7.46 +/- 2.25%. The central bank cut its deposit rate from -0.05% to -0.20%, a record level (even though similar to what happened in 2012). This peg is the main policy goal for the central bank and has been in effect since the creation of the monetary union in 1999. Can they hold the peg at these rates? I believe they can’t if the ECB goes all in.

In Sweden things seem quiet for now after the latest cut made by the Swedish Riksbank on its repo rate to zero. But over its next meeting the central bank will most likely have to cut it again, now to a negative level.

Central banks are not the only institutions hit by QE’s smoke. FXCM, once considered as the third largest global currency broker by the ECB, was severely wounded when the SNB abandon the peg. As the Swiss franc rose by 39% several FXCM clients were caught off guard and the company accumulated a loss north of $225 million. Its shares closed down 87% on Tuesday and the company is seeking to get a bailout from Leucadia National amounting to $300 million. That was much better luck than Alpari UK had when it had to file for insolvency in the advent of the Swiss action. More casualties are expected in the near future.

QE imparts strong side effects on neighbour countries because it leads to massive capital outflows.

An expansionary monetary policy should create conditions for investment to increase. Cutting interest rates and creating other conditions that help boost economic activity can help a country get back to growth in the short run. But when the central bank goes beyond its own limits, by expanding its actions to the point of completely erasing any incentives for savers, the side effects deriving from such a policy outpace any positive effects directly coming from it.

Consumers and real investors are not willing to borrow at zero rates because they don’t see good opportunities to apply the borrowed money. Decreasing the incentive to save will lead to desperate actions as people seek decent yields. It will lead to capital outflows, it will create severe problems in neighbouring countries, it will depress the savings rate and will lead to some dubious investments that will turn unfeasible at the very first rate increase.

At this point I wonder whether it wouldn’t be better to just print the €500 billion the ECB is expected to purchase in assets and give them to the population – a massive helicopter drop, as referred by Milton Friedman in 1969. With 335 million people living in the Eurozone, the ECB could give each one around €1,500, or even expand the program to €1 trillion and make it €3,000 each. That way, the ECB wouldn’t have to convince banks to sell bonds; current prices and future expectations would undoubtedly rise, avoiding the so-feared deflation monster; people would increase spending; and the redistribution issues that arise with a concentration of money printing in financial assets wouldn’t happen.

Regarding what will happen tomorrow, expect huge volatility coming as the bots will try to explore the wording used by Draghi as he speaks, before everyone else does. So the better approach for the foreseeable future is to use options covering either side. Limited liability and margin for volatility is the trick here. Any other alternative would be gambling.