Thursday, September 11, 2014

Super Mario is Dusting Off his Monetary Bazooka: What’s Next?

by Sprout Money


The long-expected meeting of the European Central Bank last Thursday was followed very closely by economists and investors. After the additional stimulus measures taken in June, the ECB once again lowered its main interest rates and the deposit interest even decreased into negative territory.

The benchmark rate was lowered to 0.05% (vs 0.15% previously) and the deposit interest decreased to -0.2% whilst the lending rate was lowered to 0.3%, coming from 0.4%. On top of that, the ECB will pump an additional 1,000 billion euro into the Eurozone’s economy which will enhance the liquidity as the ECB will purchase asset-backed securities and covered bonds with the money. The requirements and conditions for these purchases will be announced in the next monthly meeting in October.

This news doesn’t really come as a big surprise as the markets already realized in August that the ECB was changing its strategy after the comments made by president Mario Draghi in Jackson Hole. The deflation-threat as well as the disappointing credit numbers in the Eurozone needed to be dealt with. However, there are also some opposing arguments predominantly from the ‘real’ economy as not a lot of households notice an influence in their daily life. The problem is that this dirt-cheap money is being invested on the capital markets rather than being used to help those who need it the most. So even though a 1,000 billion euro blank cheque sounds impressive, it’s absolutely not certain that the this will lead to an increased lending activity in the private sector which should boost the inflation or inflation expectations.

And that’s the problem. You can lead the horse to the water, but you cannot make it drink. The unemployment rate in the Eurozone is 11.5% which is still very high and this situation is quite different from the situation in the USA where 200,000 new jobs are being created every month. Additionally, the inflation rate decreased further and by August it had shrunk to just 0.3%.

The most important victim of the new ECB policy will be the EUR/USD exchange rate. As the next chart shows, the Euro sank immediately after the announcement and at this moment, the Euro is at its lowest level versus the US Dollar in 14 months. The ‘expensive’ Euro has been a cause of concern of policy makers for quite a while now as it undermines the competitiveness of the European industry and mainly the net exporting companies and countries. The EUR/USD exchange rate has now decreased by approximately 7% since the May high.


Another important element we will have to keep an eye on is the balance sheet of the ECB. Mario Draghi hinted at the possibility to expand the balance sheet once again to the level of 2012. This would be an increase of 1,000 billion euro, and the impact of the recently announced measures on the balance sheet of the ECB remains uncertain.

After the introduction of the LTRO’s in June several market spectators were quite positive, but the expected impact of that specific measure was relatively small. And even with the most recently announced measures, the ECB is still trailing the other central banks on the liquidity creation-level. As you can see on the next chart from Bloomberg, the total balance sheet of the ECB has shrunk by 35% compared to the summer of 2012. Meanwhile, both the Federal Reserve and the Bank of Japan have increased their respective balance sheets.


However, the ECB has now clearly understood that the low inflation was reaching a very risky territory at the current rate of 0.3%, but it’s clear that there’s a long way to go before the ECB’s balance sheet will be at the same level of its international counterparts. Additionally, there’s an internal twist going on as the vote to expand the balance sheet wasn’t unanimous. It’s important to note that the president of the Deutsche Bundesbank, Jens Weidmann, is resisting against the current low yield environment and the various stimulus programs. That’s not really a big surprise as the Germans have historically always been cautious about inflation.

So what’s the main takeaway for investors? It’s clear that the conservative investor with just a savings account will be off the worst because the interest rates will very likely continue to decrease. Investors are actually being forced by the ECB to invest in products with a higher risk to get any return. Anyone who wants to have a serious solution for this problem and wants to safeguard his purchasing power will inevitably have to invest in tangible assets and will have to reduce its position in fixed income investments (mainly bonds from the core countries of the Eurozone). At Sprout Money we consider ‘tangible assets’ all asset classes which cannot be created out of thin air by the central banks.

Good examples are real estate, commodities, gold, gold mining companies but also share positions of qualitative companies with an excellent track record with a decent (and preferably continuous increasing) dividend to cover the inflation. Who’s just standing like a cow in the pasture looking at a passing train might have a serious issue when the inflation rate suddenly increases within the next few years. Aim to safeguard your purchase power and protect your capital, as at this moment capital preservation is even more important than returns on investment.

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