The Badger of Broad Street asks: What next for Europe?

I’m just back into the Badger’s holt after spending a couple of weeks in the South of France. What European recession I ask? Deflation? A baguette from a top French restaurant in London is cheaper than a backstreet baker in Aix.

My French friends were split between those who consider Hollande a dangerous mad fool and those who consider him just a fool. Everyone acknowledges that France needs an aggressive reboot of its red-taped encumbered society, but to suggest working more than 35 hours a week is utterly unacceptable.

The first thing I looked when I crawled back into the office were European bond yields. Guess what, they are tighter and tighter.

Spain 5-year bonds pay less than a 1% yield – which is pretty rich for an economy with massive youth unemployment, rising debts and a banking system with foundations made of sand. Yet everyone is buying European Government bonds – not because they believe that Europe’s sovereign debt is less risky to default threats, but because everyone now expects the ECB is going to do something spectacular that will cause European bond prices to rise even higher.

Real debate does seem to have started within the ECB, namely regarding what they are going to do to set Europe into growth mode? So we heard lots of speculation about what the ECB intends to do with QE following Mario Draghi’s comments at Jackson Hole last week.

We’ve heard political pushes for renewed government spending programmes.

Unfortunately I expect Draghi, the great pontificator, will find himself so hemmed in by the vast compromise that is Europe that he’ll do less than expected. He’ll pretty much do the wrong things because these will be all he can do – although that won’t immediately be apparent. 

Draghi and the markets would be wise to pay attention to what Japanese premier Kuroda said at Jackson Hole. His key takeaway was deflation destroys incentives for companies to invest or hire. Japan has been a deflationary basket-case for 20 years, so Kuroda knows what he’s talking about. You can talk about government spending, easy money and QE, but the critical issue is changing the economy by liberating it from red-tape and encouraging growth. Thatcher gets credit for initiating that process in the UK.

Deflation is a fact across Europe.

But how is the ECB going to address it? By flooding the markets with money? It does sound like the ECB is close to some version of QE. Apparently it has engaged Blackrock to advise on how their bond buying programme should operate. We’ve got plenty of ideas for them – like don’t buy Euros. 

It makes me giggle to think that Europe and every investor invested in Europe now sees QE as the one and only hope to kick-start the benighted continent’s moribund economy. Lest we forget, QE has previously been described as “trying to push a 100 tonne weight uphill with a length of wet wool.”

The mechanism is supposed to flood markets with liquidity so more money is invested in growth. But, if I was a European bank what would I invest in? The dismal prospects of the European manufacturing sector outside Germany? Or, should I buy yet more European government bonds backstopped by QE and Draghi promises?

QE in the US sort of worked on the basis it provided a solid footing for markets which encouraged the naturally entrepreneurial “animal spirits” of the US economy to take hold and resume growth. But the jury is still out on whether it worked or was just a massive liquidity distortion that generated modest “feel-good” on the consumption side of the economy.

But I doubt anything similar will happen in Europe. The problems aren’t so simple.

For a start, most of Europe is simply using the wrong currency – inappropriate to their competitive position relative to Germany. The functional effects of QE bond buying will be very different in Europe – it will simply further distort the demand for government bonds and push them to even higher unsustainable levels.

There is the additional threat that the gradual austerity reform that has been enforced on parts of Europe is replaced by a new outbreak of government spending on “infrastructure” etc. Where would that take us? Back to the Euro gravy train…? At some point financial gravity will come back into play..

So what’s the trade of the week?

Short-term this bond squeeze will play on, and even if Draghi fails to deliver on QE, European bonds are still going to ramp higher. But at some point… at some point… what went up will come down with a vengeance!  

You have been warned…

Badger