Europe takes yet another step closer to money-printing – keep buying

published 5 September 2014

140905-draghi — Draghi: wants to hammer the euro

You've got to hand it to him. European Central Bank (ECB) boss Mario Draghi is a master of market psychology.

Mervyn King, the ex-Bank of England boss, always understood the importance of market expectations. He used various tedious football metaphors to explain how being a great central banker was like being a great striker.

You'd score a goal by persuading defenders and goalies that you were going to go left, and then you'd go right. Or down the middle. Or whatever.

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But while Mervyn talked a good game, his on-pitch performance was a bit more jumpers for goalposts' than bend it like Beckham'.

Mr Draghi on the other hand well, Pele hasn't got a look-in

Draghi's goal to hammer the euro

Mario Draghi thoroughly surprised markets yesterday. He cut the ECB's interest rates even further. The ECB's key rate is now down at 0.05%.

As for the rate on money held at the ECB by commercial banks well, the banks were already being charged 0.1% for holding their money with the ECB. Now it's 0.2%.

So money's gone from being ridiculously cheap to being ludicrously cheap. How's that going to make a difference?

To the ordinary European, probably not much not right away. But markets weren't expecting any move at all. So it did exactly what Draghi wanted it to do hammered the value of the euro.

Draghi's not daft. He may not admit that he's targeting the exchange rate. But one of Europe's key problems is that the currency is too strong for most of its weaker members.

Draghi cannot force Italians and Greeks or French for that matter to make their economies more German. But he can force the euro Germany's currency to become that bit more Italian.

A weaker currency can help a lot. Britain avoided deflation in the last few years mainly by crushing the pound via quantitative easing (QE).The US has managed to keep the dollar low and boost US competitiveness by doing the same. Now it's Draghi's turn.

But that's not all he did. He launched yet another central bank scheme to buy stuff in the hope that it encourages some sort of economic activity. In this case, he's buying asset-backed securities and covered bonds.

What is Draghi buying now?

First, what's an asset-backed security (ABS)?

An ABS is what you get when you mix up a bunch of loans mortgages, say. You then slice up the resulting mixture into different pieces, some of which are riskier than others. And you sell off the pieces to investors looking for income.

This is known as securitisation'. You may recognise it from the subprime crisis all those toxic mortgages that were bundled up and sold off, triggering the end of the financial system as we knew it.

But don't let that bother you too much. We're way too far down the financial rabbit hole these days to question whether it's wise or not to stretch the link between creditors and end borrowers to the point where we only remember it even exists when something goes horribly wrong.

So, getting back to the ECB's cunning plan...

The ECB wants to buy a load of ABS (it didn't say exactly how much yet the exact details follow next month). We're talking mortgage loans and small business loans here. He'll only buy the top tranches' that is, the safest bits. But he's also suggested he'll buy the riskier bits if national governments are willing to guarantee them, according to Ralph Atkins in the FT.

That's actually a pretty smart-sounding move. The ECB acts as a guaranteed buyer. So governments should be happy to guarantee the loans. If the governments guarantee the loans, then banks should be happier to write them. So the ECB gets to encourage governments to do some backdoor government spending, without actually breaking ranks with austerity'.

Of course, the core problem is that Europe's banks are still bust. So the chances of them suddenly embarking on a lending and ABS-creating spree seems minimal for now.

And it's not quantitative easing not in the style we've grown used to in the US and the UK, where government bonds are bought. Germany still adamantly opposes that.

But all that this means is that Draghi can go still further.

What does this mean for investors? Simple: buy Europe

As far as UK investors go, the point of all this is quite simple: whatever the details of Draghi's plan, he is gradually pushing closer to full-blown money-printing. Even if he never gets there, markets will keep assuming he is.

So keep buying eurozone markets. Italy, one of our favourites, still looks cheap. And Europe-wide, markets certainly look better value than the US, which is expensive on most long-term measures. (That's not to say it can't get more expensive, but we prefer to buy cheap markets were possible.)

We'll be looking at Europe in more detail in the next issue of MoneyWeek magazine. If you're not already a subscriber, you can get your first four issues free here.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.