The Swiss central bank just gave the market a massive slap in the face.
In September 2011, the Swiss decided they couldn’t allow the Swiss franc to get any stronger against the euro. They imposed a minimum value of 1.20 Swiss francs to the euro.
Yesterday, completely out of the blue, they ditched that plan. The Swiss franc immediately shot up to parity with the euro and beyond – in other words, you’ll now get a lot more euros for a Swiss franc than you did this time last week.
This sort of spectacular move in a major currency is the kind of thing that rattles markets. And it will probably have lots of knock-on effects – many of which may not become clear for quite some time.
But the sudden move does imply one big thing that could end up being very profitable indeed for canny investors.
The Swiss central bank stops trying to hold back the tide
My colleague John Stepek wrote all about the background to the Swiss decision yesterday. You can read it here.
But I’m mostly interested in what it implies for one specific event – the European Central Bank’s (ECB) big decision day next Thursday.
Here’s why this is so important.
For the last three years or so, there has been a tug-of-war between Germany and the rest of Europe.
Most of Europe wants the ECB to copy the rest of the developed world’s central banks. Turn on the printing presses and pump as much money as it takes to create inflation or at least secure the banking system and allow governments some hope of ever tackling their vast public debts.
But the Germans are worried that if the ECB does quantitative easing (QE) then Germany will pay the price in the form of inflation. And meanwhile, the ‘lazy’ countries will just backslide into their old ways rather than reforming their economies.
So far the ECB’s Mario Draghi has made a lot of convincing promises, which has papered over the cracks. But he hasn’t yet actually done anything.
So until this week, you could be forgiven for doubting that QE was on the cards for this month either.
But two big things have happened this week. Yesterday’s move by the Swiss suggests that they expect QE to happen. Why? Because if QE happens, the euro will tank. That would mean the Swiss central bank would have to spend even more money on propping up the euro versus the Swiss franc.
That’s politically unacceptable – the Swiss National Bank’s balance sheet has already expanded hugely in its efforts to keep the Swiss franc weak. Remember the recent Swiss gold referendum? That was fuelled by this particular concern.
So the fact that the Swiss have now given up defending their line in the sand suggests that they knew the jig was up.
The legal hurdles to QE are tumbling down
But another hurdle was cleared this week too. In the middle of the week, the European Court of Justice (ECJ) made it much easier for Draghi to ‘go large’ on QE.
Some time ago, a group of Germans took the ECB to court. They wanted to prevent it from buying the bonds of eurozone countries. This was a challenge to guarantees that Draghi gave back in 2012. But it would have scuppered QE too, as it relies on buying government debt.
In 2014, Germany’s top court basically backed the challenge. It ruled that QE-type policies would interfere with the fiscal policy of member states – something that would violate the German constitution. It also decided that it amounted to using monetary policy to finance government borrowing. ‘Monetising the deficit’ is banned under EU law.
However, the court made a key concession – it bounced the whole thing up to the ECJ. After all, the main issue was whether or not bond buying would break European law. (And the Germans – or any other single country – can’t be seen to be dictating to the rest of Europe what to do).
So this week, the ECJ finally published a draft opinion by its advocate (a senior official). While it accepts that the German critics have a point, it says the German court was wrong and that the ECB can in fact buy the bonds of member states. Their argument was that “ever closer union” trumps everything else.
Now, technically this opinion is not binding. The ECJ’s justices could come up with a totally different answer when they come to make a final judgment in a few weeks’ time. But this happens very rarely.
Some argue that the German courts could take a look at it again and perhaps even order the Bundesbank not to co-operate with any QE programme. But that level of defiance would be unrealistic in the extreme – it would go against all the principles of EU law and almost certainly kick off a political crisis.
In short, this looks like the end of the road for legal delays to QE.
Keep buying European stocks
And as far as the economic rationale for QE goes – well, it’s looking pretty decisive. The eurozone as a whole is in deflation. Yes, it’s mainly down to falling oil prices. But the bottom line is that it’s all the excuse Draghi and the ECB need to argue that QE is needed to get inflation anywhere close to its target level.
So how big will Draghi go? The current consensus is that he will probably start small – at around the €500bn mark. But we suspect – particularly given the Swiss reaction – that it may well be a lot higher than this.
Think about it. Once he launches QE, Draghi has to convince the market that a) he’s in charge, and b) that he really will do ‘whatever it takes’. So he either has to do nothing at all (but with the promise of future action) or he has to go in all guns blazing. Taking the middle road will just convince markets that Germany has nobbled him.
And as we’ve said before, one thing we know about QE is that regardless of its impact on the economy, it’s good news for asset prices. So we’d keep buying eurozone shares.
If you feel very punchy, you might try a punt on Greece (they could potentially be excluded from QE, but the market is dirt cheap). The easiest way in is via the Lyxor ETF FTSE Athex 20 (Paris: GRE).
We like Italian shares too. They’re no longer the bargains that they were a few years earlier, but at a cyclically-adjusted price/earnings ratio of less than ten, it’s one of the cheapest markets you can find. The best exchange-traded fund for UK investors is iShares FTSE MIB (LSE: IMIB).
We have more on why Europe is one of our favourite markets for 2015 in our complete guide to investing for the year ahead, which you can get free when you sign up for a MoneyWeek subscription. For a limited time, you can also get your first eight issues for free. So if you’re not already on board, don’t delay another minute – more details here!
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