Tomorrow morning the European Central Bank (ECB) will make an announcement on monetary policy and will most likely announce the beginning of their own Quantitative Easing. I was a bit skeptical of this until last week when the European Court of Justice made it now legal for the ECB to engage in Quantitative Easing and the very next day the Swiss National Bank ended the Swiss Franc peg to the Euro.
To me, this clearly says that the ECB is going to announce a new QE program (as is pretty much expected by everyone at this point). However, it’s the amount and structure that will come under scrutiny. Too little and stocks will most likely fall pretty hard. Too much and the Euro could tumble, sending the US dollar higher and staging the risk of another bout of global “risk off” as oil and Emerging Market assets get hit. Basically, they need to find the “Goldilocks” amount of just enough. I don’t blame the Swiss National Bank for making what I’m sure was a very difficult decision that will create a lot of pain for both their economy and their people. After printing 100% of GDP in 3 years, I guess they decided enough was enough and the cost of continuing the program after the ECB begins QE is just too much. Switzerland also dropped their deposit rate to negative 0.75% and their 10-year government bond is also trading at a negative yield! That means people are willing to pay Switzerland to hold their money because losing 1% is better than losing a lot in another currency (meaning you can actually receive a net gain by paying 1% but earn a lot more as your home currency depreciates against the Swiss Franc).
So what should we expect from the ECB tomorrow? Many estimates right now are looking for at least €500 billion. Higher estimates say it could be as much as €2 trillion! However, I see the more important matter being how the program is structured – meaning who receives the benefit of interest paybacks. Regardless the amount, it’s still just a Band-Aid that will only make the imbalances between European nations worse.
When we look around at European government bond yields, most maturities under 10 years are now posting negative yields! The German 10-year is around 0.50%… I think it’s important to understand that 2008 was the top of the hill and we’re now on the decline. Western governments have gone beyond the limit that their economies can support and now hold too much debt and have made too many promises. Their solution is repeatedly to raise taxes but they don’t seem to understand how much that sucks the life out of the economy and is extremely deflationary (which raises the cost of their debt). This runs the risk of a deflationary debt-spiral. Europe is facing a situation that could be worse than Japan has experienced over the past 20+ years. The longer they put off fixing the structural issues of the Eurozone, the bigger this will come back to bite them. Trust me, QE will be around for a very long time.
This means that the factors that will drive the investment markets (and have been lately) have changed dramatically. Hold on tight, it should be a wild ride!
On a similar note, here’s the letter I sent to my client’s earlier this month. Enjoy!
-Nick