Last Thursday, Draghi — with his distinctive Italian accent — announced that the ECB will undertake its largest stimulus program ever. From March onwards, the ECB will purchase €60 billion worth of government bonds each month. The program will run for nineteen months and will amount to a total of €1,140 billion (around 8.8% of Eurozone GDP). After this announcement, the euro
Last Thursday, Draghi — with his distinctive Italian accent — announced that the ECB will undertake its largest stimulus program ever. From March onwards, the ECB will purchase €60 billion worth of government bonds each month. The program will run for nineteen months and will amount to a total of €1,140 billion (around 8.8% of Eurozone GDP). After this announcement, the euro plunged to its 11-year low. Gold benefitted as well. Gold investors were the big winners of this week because, next to the weaker euro, the gold price in dollars increased as well. Since its low thirteen months ago, gold has already risen by over 30%.
European investors are also starting to discover the role of gold during a currency crisis. Now that the euro has fallen into a downward spiral, investors flee towards save haven provided by gold. An investment in gold has been very beneficial to people who saw their euro’s decline in value relative to the dollar. A vacation away from Europe is becoming more expensive, and so are imported goods. Corporate profits of companies that obtain the majority of their revenues outside of the Eurozone will temporarily improve.
Interest rates have declined to new historical lows. The interest rate on Dutch 4-year government bonds is negative and the 5-year interest rate is on the verge of becoming negative, as is the case in other Western-European countries. How is your pension fund supposed to make a decent rate of return? What are the consequences for banks and, correspondingly, on the interest rates on mortgages and savings? What will happen to the confidence in the euro? What are the political implications for countries like Germany and Finland? Obviously, these are the perfect conditions for significantly higher gold prices in the future.
The euro could drop even further, although we have reached a point where the negativity is so intense that a reversal may happen quick and sudden; perhaps later this year.
Initially, I expected that the ECB’s stimulus program would disappoint. As is widely known, the Netherlands and Germany are among the countries that are strictly opposed to central bank purchases of government bonds. Rightly so, considering that the ECB finances the state with its unlimited resources, but sooner or later passes the bill to the citizens, most often by means of inflation.
Draghi didn’t want to go into politics, he thought, but now finds himself in a dirty political game. The Italian Prime Minster urgently called upon his compatriot to start the printing press, while the Germans were horrified by a central bank buying long-term government bonds.
The solution was therefore highly complicated. The program was a little larger than the market anticipated (€60 billion per month, instead of €50 billion), but its initial time horizon was a little shorter than expected. Moreover it was agreed that the financial risks should mainly remain at the national level. For example, the Dutch Central Bank (DNB) buys 80% of the Dutch share. The Dutch share amounts to 4% of the monthly €60 billion, which is based upon the capital key; a division based on each country’s GDP and population. The potential losses due to, for instance, bankruptcy thus accrue to the national bank of the country concerned.
In sum, the ECB and DNB will buy €2.4 billion of Dutch government bonds each month (the ECB 20% and DNB 80%). By the end of the program, this will amount to around 10% of the entire Dutch national debt.
The ECB’s decision of past Thursday is one big political compromise, despite Draghi’s intense desire not to become a politician.
The companies listed at the New York Stock Exchange obtain a large of their revenues abroad, for example, in Europe and Asia. IBM, for example, obtains 64% of its revenues outside of the U.S. Or take McDonalds: 66%. Nike: 50%. And we could easily continue like this for a while …
On the short-term, currency fluctuations will be hedged. However, as soon the hedges expire, these companies will see their profitability collapse under the weight of dropping EUR/USD exchange rates.
Draghi’s bazooka will lead to profit warnings in the U.S., considering that domestic revenues will not compensate for forex losses.
There is one major difference between the U.S. quantitative easing stimulus program that was discontinued last year, and the one that the European Central Bank (ECB) will launch in March. What difference am I talking about?
The Federal Reserve pays 0.25% annually on excess reserves (around $2,400 billion, or $6 billion in interest annually). This is a riskless return. How could we possibly blame U.S. banks for taking advantage of this? They use it, amongst others, to strengthen their equity.
In contrast, the ECB charges banks 0.2% for parking money at the European Central Bank.
The fact that the growth in the money supply (the monetary basis, or M1) did not lead to higher consumer prices and inflation, was mainly due to the unprecedented increase in commercial bank excess reserves held at the Fed (from practically zero to the abovementioned $2,400 billion).
The negative discount in Europe will therefore make substantial inflation far more likely to happen.
For this reason, it is of crucial importance to monitor what European banks will do with their reserves held at ECB this year.
Past Thursday, Draghi was asked what answer he could give to the critics who warn for higher inflation. His best attempt was: “If their argument is right, then why don’t we already have inflation?” A lousy justification for the largest monetary intervention of the ECB in history.
The Greek elections next Sunday keep the hands of the ECB tied. This was one of the reasons that I expected a postponement of the asset purchasing program.
It was therefore remarkable that Draghi did not make a single reference to Greece at the announcement past Thursday.
The truth came out later: Greece is pending a ruling.
Greek Prime Minister Antonis Samaris shed light on this issue; Greece will only take part in the asset purchasing program if the ongoing evaluation of its bail-out program has a positive outcome. Obviously, the bailout was only provided conditional on the execution of structural reforms and austerity measures.
In short, the ECB waits until the election results. If the opposition party Syriza wins, it seems that Greece will not become a part of the asset purchasing program.
This exclusion could be a reason for Syriza to leave the euro, especially when countries like Germany and the Netherlands refuse to take losses on the support that has already been provided in the past.
It is not a risky bet to state that the euro in its current shape will survive for a long time; Greece’s future in the common currency is the first thing that comes to mind.
I cannot help but thinking that the Swiss National Bank has been informed by the ECB that is was about to announce its largest asset purchasing program ever.
Such a program would imply that Switzerland would have to hoard even larger quantities of euro’s, putting Switzerland in an impossible position.
Other central banks were apparently less fortunate (or lacked close contacts).
Denmark, for example, faces enormous difficulties in maintaining the peg with euro. A smart investor would definitely consider buying a call option on the Danish krone. I'm still in doubt.
Finally, I would recommend you to join me weekly this year, in order to read whether the ECB’s negative discount rate and its asset purchasing program will indeed lead to an unchecked credit bubble, a flight into very, very risky assets, and growing inflation.