Is the European Central Bank (ECB) ever going to turn on the printing presses?
With deflation threatening the eurozone, investors had expected ECB boss Mario Draghi to at least discuss the need to do something when he gave a press conference last week. If nothing else, talking down the euro might help buoy the weaker eurozone economies.
But instead he actively downplayed the risk of falling prices. As a result, the euro shot higher.
Meanwhile, Germany’s highest court decided that the ECB’s big proposed bailout scheme – the fabled ‘OMT’ – exceeded its powers. This could kick the OMT into the long grass for at least two years as it bounces between Germany and the European courts.
It looks like Berlin and Brussels plan to have their cake and eat it. The threat of money printing stops investors from driving up borrowing costs for troubled nations. But they never actually follow through, which keeps the Germans happy.
Can they pull this big con game off? Is it time to buy the euro?
I suspect not. But you can profit either way…
Brussels can be creative and flexible when it has to
OMT stands for Outright Monetary Transactions. This scheme would allow the ECB to buy the bonds of troubled eurozone countries directly, driving down their borrowing costs. The mere threat of OMT stopped the exodus from eurozone bonds dead in its tracks in 2012, with Draghi’s “whatever it takes” speech.
But the OMT has never been activated. That’s partly because it’s never actually been approved.
The idea of the ECB buying bonds is not popular with many Germans. They see it as a backdoor bailout. Why would the Greeks ever restructure their economy if they can get free money from the ECB? The Germans also worry that ECB money printing could lead to inflation.
So Germany challenged the OMT on the grounds that it exceeds the ECB’s power. And last week, Germany’s Constitutional Court voted to refer the matter to the European Court of Justice.
Some people think this really makes things tricky for the ECB if it wants to start printing. But I’m not so sure.
We now have a situation where an EU court is going to decide whether the ECB has too much power. Call me cynical, but it rather looks as though the German Constitutional Court wants to appear tough (to appease the Germans), while tacitly approving the OMT.
Even the risk of delay might be overstated. Brussels likes to insist that eurozone countries implement European Union law to the letter. But as we all know, it is prepared to be ‘flexible’ and ‘creative’ when it suits, as shown by the fact that auditors have repeatedly found significant material errors in the EU’s accounts. So expect them to devise a way around this if push comes to shove.
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Will the ECB be forced to print?
So the question isn’t: will the Germans allow the ECB to print? It’s more: will circumstances force the ECB to act?
I think the answer is yes.
Eurozone banks are still unwilling to lend (because they’re still in a huge mess). That means – as has happened in the UK and the US – that the only institution that can provide the economy with the money it needs to grow is the ECB (my colleague James Ferguson has written about this regularly in MoneyWeek magazine – take a look here for a more detailed explanation of how QE offsets falling bank lending).
But with the ECB currently sitting on its hands, monetary growth is very weak. Capital Economics notes that M3, the best measure of money supply, is only growing by 1% a year, and falling.
As a result, Capital Economics thinks the eurozone economy will barely grow at all this year. And some of the most debt-ridden countries – such as Italy – will stay in recession.
That won’t help reduce Europe’s massive unemployment. And it means countries will also miss their debt reduction targets, which may mean more austerity.
So the eurozone faces ongoing economic pain, meaning miserable, discontented voters. And there’s one man who could use this discontent to bring things to a head: Silvio Berlusconi.
Last year was a disaster for Italy’s former prime minister. He was sentenced to home imprisonment (for tax fraud) and expelled from the Senate. An attempt to bring down the government backfired when key members of his coalition failed to back him.
However, the economic pain has helped him to launch yet another comeback, reviving Forza Italia. Unsurprisingly, he has put anti-German sentiment at the heart of his relaunch.
Several former allies have re-joined his coalition, eroding the power of the current government. If you take these smaller parties into account, his coalition leads the polls with 38%.
This matters. Changes to electoral law in Italy give a big seat bonus to the largest coalition group in an election, as long as it gets over 37% of the vote.
So if an election were held today in Italy, Berlusconi could well become prime minister. Again.
Of course, there is the small matter of his ban from public office. But he is challenging this in the courts. And even if he is barred, he can delegate the leadership to a figurehead – possibly his daughter – and run things from the sidelines.
Sell the euro, buy shares
This leaves the ECB, Brussels and Berlin with the same sticky problem they’ve always had.
They can squeeze the troubled nations, particularly Italy and Greece – as long as they offset the pain with a weak euro and loose monetary policy.
Or they can keep monetary policy tight and the euro strong – as long as German taxpayers are willing to pay to alleviate some of the pain in their southern partners.
But if they want to keep the euro, they can’t have both. One way or another, the struggling countries need some sort of help or debt relief. Or eventually a populist politician will lead them to the logical conclusion – ditch the euro.
The exit of Greece or Italy can’t be ruled out completely. But it seems far more likely that when push comes to shove, money printing by the ECB will be a more palatable solution.
That would send the euro much lower from here. You can bet against the single currency by spread betting or via an exchange-traded fund. And if you fancy a dabble in the high-risk world of currency trading, you should have a look at my colleague John Burford’s free trading email, MoneyWeek Trader.
But I think there’s a better way. We already know that money-printing sends stocks higher (just see Japan, Britain and the US). And we know that stocks in the most troubled countries remain cheap, despite rallying sharply over the past 18 months or so.
So we’d keep buying the peripheral stock markets. Despite last year’s surge, the Italian market still trades on a cyclically-adjusted price/earnings ratio (Cape) of only 8.6. The best exchange-traded fund for UK investors is iShares FTSE MIB (LSE: IMIB).
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