Thursday, January 22, 2015

ECB: A Day Late and a Euro Short?

Paul Carrel and John O'Donnell of Reuters report, ECB launches last-ditch program to revive euro economy:
The European Central Bank took the ultimate policy leap on Thursday, launching a government bond-buying programme which will pump hundreds of billions of new money into a sagging euro zone economy.

The ECB said it would buy government bonds from this March until the end of September 2016 despite opposition from Germany's Bundesbank and concerns in Berlin that it could allow spendthrift countries to slacken economic reforms.

Together with existing schemes to buy private debt and funnel hundreds of billions of euros in cheap loans to banks, the new quantitative easing programme will pump 60 billion euros a month into the economy, ECB President Mario Draghi said.

By September next year, more than 1 trillion euros will have been created.

"The combined monthly purchases of public and private sector securities will amount to 60 billion euros," Draghi told a news conference. "They are intended to be carried out until end-September 2016 and will in any case be conducted until we see a sustained adjustment in the path of inflation."

Bonds will be bought on the secondary market in proportion to the ECB's capital key, meaning the largest economies from Germany down will see more of their debt purchased by the ECB than smaller peers.

The prospect of dramatic ECB action had already prompted the Swiss central bank to abandon its cap on the franc while Denmark, whose currency is pegged to the euro, was forced to cut interest rates in anticipation of the flood of money.

The Danish central bank intervened to weaken the crown ahead of the announcement.

Former ECB policymaker Athanasios Orphanides said action was long overdue. "The ECB should have already embarked on QE," he said. "Now that the situation has deteriorated, the ECB will have to do much more."

The euro fell, European shares jumped and bond yields in Italy, Spain and Portugal fell with the single currency dropping a full cent against the dollar to $1.1511.

Draghi has had to balance the need for action to lift the euro zone economy out of its torpor against German concerns about risk-sharing and potentially being left to foot the bill.

Tensions broke out as the meeting got underway with French Finance Minister Michel Sapin firing a broadside at Berlin.

"The Germans have taught us to respect the independence of the European Central Bank," he told France Info radio. "They must remember that themselves."

A German lawyer who has been prominent in attempts to halt euro zone bailouts said he was already preparing a legal complaint against an ECB bond-buying programme.


Draghi said 20 percent of the asset purchases would be subject to risk-sharing, suggesting the bulk of any potential losses will fall on national central banks.

Critics say that calls the euro zone concept of risk sharing into question and countries with already high debts could find themselves with further liabilities.

Euro zone inflation turned negative last month, far below the ECB's target of close to but below 2 percent, raising fears of a Japan-style deflationary spiral.

But there are doubts, and not only in Germany, over whether printing fresh money will work.

Most euro zone government bond yields are already at ultra-low levels while the euro has already dropped sharply against the dollar. Lower borrowing costs and a weaker currency could both help to boost growth but there is a question about how much downside there is for either.

"It is a mistake to suppose that QE is a panacea in Europe or that it will be sufficient," former U.S. Treasury Secretary Larry Summers said at the World Economic Forum in Davos on Thursday.

"There is every reason to expect that QE will be less impactful in a context like the present one in Europe than it was in the context of the United States."

A plunge in the price of oil has thrown central bankers into a spin worldwide. Canada cut the cost of borrowing out of the blue on Wednesday while two British rate setters at the Bank of England dropped calls for tighter monetary policy as inflation has evaporated.

The ECB has already cut interest rates to record lows. Earlier, it left its main refinancing rate, which determines the cost of euro zone credit, at 0.05 percent.

Greece and Cyprus, which remain under EU/IMF bailout programmes, will be eligible but subject to stricter conditions.

"Some additional eligibility criteria will be applied in the case of countries under an EU/IMF adjustment programme," Draghi said.

The move comes just three days before an election in Greece where anti-bailout opposition party Syriza is on track to gain roughly a third of the vote.
David Jolly and Jack Ewing of the New York Times also report, E.C.B. Stimulus Calls for 60 Billion Euros in Monthly Bond-Buying:
The European Central Bank said on Thursday that it would begin buying hundreds of billions of euros worth of government bonds in an ambitious — though some say belated — attempt to prevent the eurozone from becoming trapped in long-term economic stagnation.

The bank’s president, Mario Draghi, said the central bank would begin buying bonds worth 60 billion euros, or about $69.7 billion, a month. That is more spending than the €50 billion a month that many analysts had been expecting.

The long-awaited program, known as quantitative easing, comes after inflation in the 19 countries of the eurozone fell below zero and raised the specter of deflation, a sustained decline in prices that can lead to higher unemployment and that is notoriously difficult to reverse.

As a further stimulus step, the European Central Bank also said it was cutting the interest rate it charges on loans to commercial banks, as long as the banks commit to lending that money to companies or individuals. The new rate would be 0.05 percent, down from 0.15 percent.

“We believe the measures taken today will be effective,” Mr. Draghi said at a news conference.

Financial markets greeted the news favorably. The benchmark Euro Stoxx 50 index was up 1 percent. Bond yields in some eurozone countries hit new lows, including countries that might benefit most from the central bank’s program. The yields on 10-year government bonds in Italy dropped to 1.58 percent and in Spain to 1.42 percent.

The euro weakened further against the dollar, falling about 0.6 percent to $1.1543, a move that could help European exporters.

Top officials of the central bank had signaled clearly that a quantitative easing program was in the offing. But there remained, before the central bank meeting on Thursday, many questions about how large the program would be and whether it would be powerful enough to reverse a two-year decline in inflation.

Programs of quantitative easing by the Federal Reserve in the United States and by the Bank of England in Britain have helped the economies of those two countries recover from the global financial crisis more successfully than the eurozone has been able to.

If successful, quantitative easing would push down market interest rates in the eurozone and make it easier for businesses and consumers to borrow money, helping to stimulate the economy and restore inflation. Quantitative easing could also have a psychological impact, helping to raise expectations that inflation will begin to rise and thus encourage people to spend now rather than wait.

Mr. Draghi said Thursday that the bond buying would continue through September 2016 or “until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2 percent over the medium term.”

The decision to begin buying government bonds on the open market came after a debate that lasted months. Mr. Draghi sought to overcome resistance from German members of the governing council and the broader German public, which regards quantitative easing as a form of wealth transfer to countries like Italy.

Mr. Draghi acknowledged on Thursday that there had been intense discussion by the bank’s governing council about how to share the risk if a country later defaults on its debt. Mr. Draghi said that concerns about risks being transferred from some countries to others was legitimate. The compromise preserves some risk sharing, he said.

The European Central Bank will coordinate the buying, Mr. Draghi said, but will delegate some of it to the central banks of national central banks. In a further compromise, some of the risk from bond buying will be taken by the European Central Bank and some by national central banks.

Anticipating critics who might say that the European Central Bank is not in full control of the eurozone’s monetary policy if it shares the risk of its program, Mr. Draghi said, “The singleness of monetary policy remains in place.”

He said that the central bank would begin buying government bonds based on each country’s share of the central bank’s capital, which is commensurate with their population and gross domestic products.

He said that the central bank would not buy more than 33 percent of any country’s outstanding bonds, nor more than 25 percent of any bond issue. The central bank will buy the bonds on the open market, he said, to allow the market to set the price. Those conditions appear intended to address legal challenges to bond buying by the central bank.

Asked about Greece — a special case because of the political uncertainties there and because the country continues to labor under an international bailout program overseen in part by the European Central Bank — Mr. Draghi said that the bank could buy Greek bonds. But in practice, he noted, such purchases might be limited.

Greece, he said, would have to continue adhering to the terms of its bailout program, which is also being administered by the International Monetary Fund and the European Commission. That adherence is currently uncertain, as Greece awaits national elections this weekend that could result in a new government seeking to revise the terms of the bailout.

In addition, the European Central Bank already owns a large proportion of Greek bonds and would not hold more than 33 percent of the total. But in July, Mr. Draghi said, redemptions of Greek bonds could allow the central bank to buy more.

In another crucial provision, the European Central Bank would have equal status to other bond holders — rather than holding itself above other investors and expecting to be paid back first in the event of problems. That will be important to private investors, because if the central bank held itself out as a privileged bondholder, effectively passing more risk on to other bond holders, other buyers might undermine the stimulus program by demanding higher interest rates.

Although the Federal Reserve and the Bank of England used quantitative easing to rejuvenate their economies, such a program would be more complicated in the eurozone. There is no widely traded, Pan-European government bond similar to United States Treasury securities, which were the main vehicle for the Fed’s program.

Another question is whether quantitative easing can help fix the eurozone economy, especially since it has taken so long for the central bank to begin a large-scale bond-buying program. Many economists and businesspeople are skeptical.

“I do not believe it will have a major effect whatever will be announced,” said Karl-Ludwig Kley, chairman of Merck, a German pharmaceutical and chemicals company that is separate from Merck & Company in the United States.

“I do not believe bond buying or whatever is the remedy,” Mr. Kley said in an interview at the annual meeting of the World Economic Forum in Davos, Switzerland. “I do not see, because of these programs, consumers buying more. I do not see companies investing more.”
If you ask me, the ECB's new QE measures while much needed, are a day late and a euro short. I've long argued the ECB is way behind the deflation curve and the way they're going about it won't make a dent in the euro deflation crisis.

Why? Because once deflation becomes entrenched, it's almost impossible to break the cycle. Moreover, apart from the dysfunctional politics and lack of a Pan-European government bond similar to United State, the transmission mechanism isn't the same in Europe where the wealth effect from rising stocks is a fraction of what it is in America (fewer people own stocks).

I'm not the only one who is skeptical. In Davos, the Telegraph's Ambrose Evans-Pritchard reports, Larry Summers warns of epochal deflationary crisis if Fed tightens too soon:
The United States risks a deflationary spiral and a depression-trap that would engulf the world if the Federal Reserve tightens monetary policy too soon, a top panel of experts has warned.

"Deflation and secular stagnation are the threats of our time. The risks are enormously asymmetric," said Larry Summers, the former US Treasury Secretary.

"There is no confident basis for tightening. The Fed should not be fighting against inflation until it sees the whites of its eyes. That is a long way off," he said, speaking at the World Economic Forum in Davos.

Mr Summers said the world economy is entering treacherous waters as the US expansion enters its seventh year, reaching the typical life-expectancy of recoveries. "Nobody over the last fifty years, not the IMF, not the US Treasury, has predicted any of the recessions a year in advance, never."

When the recessions did strike, the US needed rate cuts of three or four percentage points on average to combat the downturn. This time the Fed has no such ammunition left. "Are we anywhere near the point when we have 3pc or 4pc running room to cut rates? This is why I am worried," he told a Bloomberg forum.

Any error at this critical juncture could set off a "spiral to deflation" that would be extremely hard to reverse. The US still faces an intractable unemployment crisis after a full six years of zero rates and quantitative easing, with very high jobless rates even among males aged 25-54 - the cohort usually keenest to work - and despite America's lean and efficient labour markets.

Mr Summers warned that this may be a harbinger of deeper trouble as technological leaps leave more and more people shut out of the work-force, and should be a cautionary warning to those in Europe who imagine that structural reforms alone will solve their unemployment crisis.

"If the US is in a bad place, we are short of any engine at the moment, so I hope you are wrong," said Christine Lagarde, the head of the International Monetary Fund.

Mrs Lagarde said the IMF expects the Fed to raise rates in the middle of the year, sooner than markets expect. "This is good news in and of itself, but the consequences are a different story: there will be spillovers. One thing for sure is that we are in uncharted territory," she said.

Worries about the underlying weakness of the US economy were echoed by Bridgewater's Ray Dalio, who said the "central bank supercycle" of ever-lower interest rates and ever-more debt creation has reached its limits. Interest rate spreads are already so compressed that the transmission mechanism of monetary policy has broken down. "We are in a deflationary set of circumstances. This is going to call into question the value of holding money. People may start putting it in their mattress."

Mr Dalio said the global economy is in a similar situation to the early Reagan-era from 1980-1985 when the dollar was surging, setting off a "short squeeze" for those lenders across the world who borrowed in dollars during the boom.

There is one big difference today, and that is what makes it so ominous. "Back then we could lower interest rates. If we hadn't done so, it would have been disastrous. We can't lower interest rates now," he said.

“We’re in a new era in which central banks have largely lost their power to ease. I worry about the downside because the downside will come,” he said.

Mr Dalio said Europe is already in such a desperate predicament that it may have to go beyond plain-vanilla QE and start printing money to fund government spending - what is known as "helicopter money" in financial argot. "Monetisation is a path to consider," he said.

“If the moderates of Europe do not get together and change things in a meaningful way, I believe there is a risk that the political extremists will be the biggest threat to the euro," he said.

Mr Summers said QE in Europe will not do any harm - and might help a little - but comes too late to lift the region off the reefs on its own. “I am all for European QE, but the risks of doing too little far exceed the risks of doing too much. It is a mistake to suppose it is a panacea or that it will be sufficient."

He said QE in America packed the biggest punch at the start, when 10-year rates where around 3pc and there was still scope to drive them lower. Germany's 10-year Bunds are already down to historic lows of almost 0.4pc. The Fed's stimulus worked through US capital markets but most of the lending in Europe is conducted through banks, which are still "clogged".

Mr Summers said the root cause of Europe's woes is a "strategy of austerity", with grudging and belated monetary stimulus, in the misguided hope that this would somehow bring about invigorating reform. The result is instead economic malaise and a surge in political extremism.

He accused Germany's leaders of succumbing to Keynes's "fallacy of composition", seemingly unable to grasp that fiscal tightening and cuts may allow one country to steal a march on others in a currency union, but if everybody cuts spending together, it turns into a vicious spiral that holds back everybody in the end.

The eurozone states, taken together, have plenty of room for fiscal stimulus, and indeed should take advantage of negative rates to rebuild their infrastructure and invest in new technologies.

The headline reduction in budget deficits is yet another EMU fallacy, he said, accusing Europe's leaders of pursuing "fetishized" debt targets that ultimately undermine future growth and raise the future debt burden. "They are repressed budget deficits," he said.

What is holding them back is the "irresponsible decision" to launch a currency union without a fiscal union to back it up, leading to a refusal to share liabilities and a chronically dysfunctional system.

"It is a failure to recognize that the one-off model of export-led growth that worked for Germany, will work for everybody. It is a failure of generalisation. That is the central error running much of European economic thought. As long as continues to drive policy, prospects for success are very limited," he said.
I think Lawrence Summers and Ray Dalio spell it out perfectly. Go back to read my comment, Don't Fight the Fed?, where I noted the following:
The key here is whether the market perceives the Fed do be behind the deflation curve, not the inflation curve. As I've repeatedly warned, the real concern is about the Euro deflation crisis and whether it will spread to the United States. For now, global stock markets are not worried, bouncing back vigorously from the latest selloff, but this could change and the future of the eurozone remains very fragile.

In my recent comment on whether it's time to plunge into stocks,  I openly questioned Dallas Fed president Richard Fisher for dismissing the contagion effects from eurozone's deflation crisis and how it's influencing U.S. inflation expectations. 

Importantly, the biggest policy mistake the hawks on the FOMC are making is ignoring global weakness, especially eurozone's weakness, thinking the U.S. domestic economy can withstand any price shock out of Europe. If eurozone and U.S. inflation expectations keep dropping, the Fed will have no choice but to engage in more QE. And if it doesn't, and deflation settles in and markets perceive the Fed as being behind the deflation curve, then there is a real risk of a crisis in confidence which Michael Gayed is warning about. Perhaps this is the real reason why big U.S. banks are loading up on bonds (not just regulatory reasons).
In my more recent comment on why OMERS is worried about deflation, I went a step further and stated:
I want you all to keep Makin's brilliant comment in mind because as I stated in my last comment on the Swiss currency tsunami, I'm betting the Fed won't raise rates this year and might even be forced to engage in more aggressive QE if a financial crisis emerges (that's when the real fun begins!).
One thing is for sure, even if it won't make a big difference in the real economy, more QE from the ECB will help propel risks assets all over much higher, especially in the United States. Go back to read my Outlook 2015,and try to understand why even though deflation is coming, there is plenty of liquidity to drive risk assets much higher.

But Ray Dalio is absolutely right, there will come a time when more QE simply won't work and might even reinforce deflationary pressures. That's when we'll see huge downside risks materialize.

On that note, please go back to read my last comment on why the Bank of Canada shocked markets and cut rates. I added some comments from Brian Romanchuk who thinks this was a policy error, but if you ask me, Bank of Canada Governor Steve Poloz has a deep understanding of the risks of deflation spreading throughout the world and the bank was right to cut rates.

Also, markets will now be focusing on Greece and whether we'll avert another euro crisis. There will be more anxiety but I remain confident we will not see a major crisis from Greece, even if Syriza wins and manages to form a minority government.

Below, IMF Managing Director Christine Lagarde, former U.S. Treasury Secretary Lawrence Summers, Goldman Sachs Group Inc. President Gary D. Cohn, Banco Santander SA Chairman Ana Botin and Bridgewater's Ray Dalio, speak on a Bloomberg Television debate on quantitative easing. Francine Lacqua moderates the session at the World Economic Forum's annual meeting in Davos, Switzerland.

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