Europe opens the door to money printing – expect stocks to keep rising

Mario Draghi: in charge

I have to admit, as you might have picked up from yesterday’s Money Morning, I was sceptical that European Central Bank (ECB) boss Mario Draghi was going to do anything at all this week. After all, it wouldn’t be the first time he’d disappointed the markets.

But at yesterday’s meeting, he not only introduced the first negative interest rate seen at a major central bank. He also threw a pile of other measures into the mix.

The market didn’t know quite what to make of it. It wasn’t full-blown money-printing, UK or US-style. But it wasn’t nothing either.

So what did he actually do? And what does it mean for your money?

Our monetary system is crazy

Let’s make one thing clear here before we get started. I think it’s obscene that central bankers have this much influence over global financial markets. It would be laughable if it wasn’t so serious.

People keep prattling on about the low volatility in financial markets right now, like it’s a big mystery. It’s not. It’s because no one wants to do anything or take a position because every week, someone like Draghi or Janet Yellen or Mark Carney is scheduled to open their mouths and send everyone into a momentary spasm of panic and second-guessing about monetary policy.

Markets have been on tenterhooks all week waiting for Draghi to speak. The fact that the words of one man can have so much impact – regardless of how short-term it is – will surely one day strike us as madness.

Historians will look back and say: “How did these people imagine they lived in a market economy when the most important variable – the reward on offer for taking a risk – was constantly being manipulated by small committees of academics and economists, steeped in flawed theories and beholden to politicians?”

However, as investors we live in the world as it is, not as we want it to be. So it’s our job to navigate this madness as best we can. So how might Draghi’s latest moves affect your portfolio?


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The road to eurozone money-printing

Firstly, Draghi cut interest rates in the eurozone. This wouldn’t be a big deal – they’re already practically at zero – save for one thing: one key rate has actually now gone negative.

The bank will now pay -0.1% interest on any money commercial banks leave with it. In other words, they’ll get charged interest on any money they deposit with the ECB.

The idea is that they’ll stop holding money with the ECB and go and lend it out or do something more useful with it. The problem, as George Magnus notes in the FT, is that banks in the eurozone aren’t in fact holding a great deal of money with the ECB right now. So a big change in their behaviour isn’t likely.

But Draghi didn’t stop there. He’s put another €400bn up for grabs to banks over four years. (The acronym for this, should you care, is TLTRO – ‘targeted long-term refinancing operations’). This is like ‘funding for lending’ in the UK. The banks get to borrow money on the cheap as long as they agree to lend it to businesses.

He also said the ECB was working on a scheme that would allow it to buy ‘asset-backed securities’ – packages of small business loans, basically.

Will this stuff ‘work’?

Often the best way to work out how effective any of this stuff is, is simply to look at the market reaction. The euro absolutely tanked as Draghi chatted away at his press conference. But after he sat down, it rapidly rebounded.

That suggests that investors thought they were going to get the monetary equivalent of the ‘full Monty’ – full-blown money printing (quantitative easing). Instead, Draghi teased them by doing lots of other stuff, but not quite going all the way.

So at first glance, it doesn’t look like it’s had much impact.

But I’m not so sure. Yes, the scale of what Draghi has done is small. This is not like the Bank of Japan suddenly turning around and pumping a big chunk of GDP into the economy.

However, the very fact that Draghi was able to act with this level of conviction at all suggests that he’s now in charge. One key point that Gavyn Davies pulls out in the FT is the decision to stop ‘sterilising’ the ECB’s earlier purchases of government debt. This gets a bit technical, but what it boils down to, as Davies says, is that “for the first time, the ECB is financing these purchases by creating money.”

In other words, it’s a form of ‘proper’ QE. And if he’s managed to get this past the Germans, then – as Davies points out – “the Bundesbank will now find it harder to object on principle” to a bigger dose of QE in the future.

In short, what matters is that before now, Draghi had nothing but promises and words. Now he has proved that he actually has the ability to do “whatever it takes” to save the eurozone. And that can surely only be good news for eurozone stock markets.

James Ferguson of the Macrostrategy Partnership will be writing all about Europe and the latest moves by Draghi – as well as what it all means for investors – in the next issue of MoneyWeek magazine, out next Friday. If you’re not already a subscriber, you can get your first four issues free here.

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2 Responses

  1. 07/06/2014, uncommercial wrote

    Markets are regulated – fact. Banks create money – fact. In theory, we’re better off if governments regulate rather than companies, and governments control banks, since governments are supposed to be accountable. In practice, there doesn’t seem to be much difference. But the idea that there could be completely unregulated markets is a fairy tale. As for Europe, the ECB’s aims are to avoid deflation (by aiming for a moderate level of inflation) and reduce the value of the euro. Without currency hedging, it’s unclear whether rises in equity values will outrun falls in the euro. With hedging, other things can go wrong. As usual, the future is uncertain.

  2. 07/06/2014, Beta Adjusted wrote

    Hmm, actually, equity prices will outrun the fall in the Euro for a number of reasons:

    (i) Economies are very sensitive to exchange rates. A 5% fall in the EUR would have quite a significant benefit to European exporters. I actually don’t fully understand why this is, but have seen enough charts to know its true.
    (ii) Operational leverage. More revenues from exports means a lot more profits for exporters because they tend to be very operationally geared.
    (iii) The effects of (i) and (ii) lead to more investment by companies, lower unemployment, higher wages etc. The consumer is a significant proportion of Eurozone economies.
    (iv) The effects of (i), (ii), and (iii) lead to an improvement in bank balance sheets, and an increase in demand for credit. Improvement in bank balance sheets increases lending, and thus an increase in the money supply via the money multiplier effect.

    All of these lead to the next economic boom. Expect earnings revisions to go recover, and with so much capacity removed from cyclicals, expect cyclicals and small caps to enter the next boom market. The future is less uncertain than you fear!

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