The ECB’s Bazooka Should Send European Stocks Higher
The European Central Bank (ECB) unveiled a monetary bazooka at its press conference on January 22nd by announcing it will begin buying Euro 60 billion worth of bonds every month from March 2015 to September 2016 – or even longer if necessary to push inflation expectations back toward its 2% target. This launch of ECB Quantitative Easing (ECB QE) is a very important development that is likely to push European stock markets significantly higher. It may also revive Europe’s weak economy - at least temporarily over the next couple of years.
Here’s how the ECB expects this policy to work. First, it will cause the Euro to depreciate against the US Dollar. In fact, the Euro has already fallen by 16% against the Dollar as investors were led to anticipate this development over the last six months. The lower Euro will boost industrial production in Europe by making European products less expensive outside Europe, thereby boosting exports, and by making goods made outside Europe more expensive for Europeans, thereby deterring imports. Similarly, the weaker Euro will attract many more tourists to Europe, while discouraging Europeans from travelling abroad.
Next, when the ECB buys Euro 60 billion worth of bonds each month, it will push up the price of those bonds and thereby push down their yields (i.e. the rate of interest they pay investors). This will push down interest rates not only on government bonds, but also on corporate bonds and mortgages, which should encourage more borrowing, investing and home buying.
Third, as the ECB buys Euro 60 billion worth of bonds each month, whomever they buy the bonds from will have Euro 60 billion in cash that they will have to invest in other Euro-denominated assets such as stocks. That means stock prices are likely to rise, making investors “wealthier”, thereby allowing them to consume more. Higher consumption will mean more economic growth. Central bankers refer to this process as “portfolio rebalancing” leading to a positive “wealth effect”.
Make no mistake, the creation and investment of Euro 60 billion a month (Euro 1.1 trillion over 19 months) is a very big deal. The yields on European government debt have already collapsed to new historic lows over the last two weeks even before the program’s implementation begins. The yield on 10-year German government bonds fell to 0.27% on January 30th, lower, astonishingly, than even the 0.30% offered on 10-year Japanese government bonds. Even the yields on 10-year government bonds in Spain and Italy, where government finances are considered to be weak, have fallen to only 1.45% and 1.58%, respectively.
Such ultra low returns on “risk free” government bonds will force investors to move into riskier assets in search of higher income. That move will make more money available for riskier investments, which could boost economic growth. The problem with this, of course, is that many of those riskier investments are likely to fail. When they do, rather than providing investors with a higher return, they will destroy the investor’s capital instead.
As in the United States, credit growth drove economic growth in Europe for decades until 2008 when it stopped expanding. The success of ECB QE over the longer run, therefore, will depend on whether it causes credit in Europe to begin growing again. Unfortunately, the prospects of that occurring are less than promising. The level of credit (i.e. debt) is already too high relative to income in Europe – just as it is everywhere else in the world. Always remember, the crisis in the global economy boils down to just one thing: globally, there is too much debt relative to income. This crisis will not end until the wages of the middle and lower income groups begins to increase again.
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