Out of the Box: The ECB hits the Warpath, Again
Mr. Draghi’s speech in Sintra, Portugal, yesterday, was reminiscent of his famous “Whatever it Takes” speech. Mr. Draghi said the bank had “considerable headroom” to launch a fresh expansion of its $2.9 trillion Quantitative Easing program and suggested it could, in the short term, target inflation above its medium-term goal of just under 2%, for a limited period of time. Virtually no one was expecting this. It had been thought, by most money managers, that the ECB was done with QE and while they might flat-line, that no increase in QE was in sight.
For the first time, ever, the French 10 year hit a Zero interest rate, along with Sweden, and even with the fall in U.S. rates the spreads to its European counterparts are stunning.
|COUNTRY||10 YEAR YIELD|
|The United States||2.056%|
*Data from Bloomberg
While everyone is focused on what the Fed might do, and why, I have a different concern. The markets are more global, than ever before, and the Fed, in my opinion, is no longer a stand-alone entity. In the first place the Fed is never, ever, ever, going to admit that they changed their viewpoint, and direction, because of political reasons. That just is not going to happen, as each member of the Fed raises their flag of “Independence.” They might cite inflation, a slowing economy, global issues with China, or Europe, but they will never admit to any political influence on their decisions.
It is accurate to state that the Fed was created by the Federal Reserve Act of 1913 and that it is a creation of Congress. Regardless of the banter, the Fed is not some off-shore institution and its rules and regulations can be changed by Congress, if it so wills. I have long held the viewpoint that the President, or any member of Congress, can offer their opinion on what the Fed is doing without threatening the independence of the Fed. Members of the Fed are elected for 14 year terms and they can make their own decisions, in their own manner, and for their own purposes, but the Fed is still a part of the U.S. government.
We, in America, being the world’s largest economy, tend to reflect on the Fed internally. We rarely stop to think about what the ECB or the Bank of Japan is doing and how it might affect the United States. This “internal only” view, unfortunately, does not adequately reveal the true state of the world, and it may cause very wrong decisions to be made by both money managers, and the Fed, alike.
In Europe sovereign debt is allowed to be carried “Risk Free,” by the banks. This means that no collateral must be put up against these holdings whether it is Germany or Italy or even Greece. This distorts, in my opinion, the balance sheets of the European banks which is why I am so negative about investing in any of them. Also, it means that besides the purchases of the ECB, that the banks are constantly buying sovereign debt and helping to hold down the yields of the EU countries.
The reality is, in my estimation, that the nations of Europe, given their economic conditions, cannot afford their social programs and so the ECB has helped lower rates to Zero, and less than Zero, so these nations can compete and survive economically. Frankly, all of them are in trouble but their trouble become our angst as U.S. interest rates are so much higher than theirs. This is also beginning to have an effect on the Dollar/Euro as our currency keeps strengthening.
It may be that the ECB will resume bond purchases to address the risk of de-anchoring inflation expectations. It could do so by either adjusting limits on purchases to 33% of member countries’ debt, or by tilting debt purchases toward corporates, supranational entities and/or the most indebted governments. In the former case, German Bund yields could fall even further into negative territory; in the latter, Bund yields could jump back above Zero and the yield curve would steepen.
President Trump hit out at Mr. Draghi’s remarks yesterday, suggesting that Europe was engaging in currency manipulation. “Mario Draghi just announced more stimulus could come, which immediately dropped the Euro against the Dollar, making it unfairly easier for them to compete against the USA,” the US president wrote on Twitter. “They have been getting away with this for years, along with China and others.”
Between what looks like European cuts in interest rates to come, and the strength of the Dollar, the Fed is now in a very precarious position. The United States can’t ignore these two very real threats to our economy or the threat of the continuing “Game of Thrones” battle with China. The Fed, in my estimation, has plenty of room to lower rates and they should do exactly that, so American can compete on a level playing field with the rest of the world.
Europe and China are trying to “ring-fence” the United States and I just hope that the Fed has enough clarity of vision to realize this and respond accordingly. We will all see what happens today but the most important part of their upcoming statement may be the identification of the issues that they see impacting the United States. “Getting it Right,” is critical now.
Mark J. Grant
Chief Global Strategist, Fixed Income
B. Riley FBR Inc.
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