The ECB and Mario Draghi made some fairly dramatic moves in European monetary policy last week. They weren't entirely unexpected, but the market response indicates some disappointment that they didn't do the full monty and initiate outright QE. Draghi has spoken recently about his desire to see a lower Euro and the last couple of weeks things have been going his way but the immediate aftermath of the announcement saw a brief continuation of the recent trend and then a fairly violent reversal.
The late week rally in the Euro capped a recent rise in the U.S. dollar index keeping it well within its range of the last two years. It is a bit curious that despite all the central bank shenanigans of the last few years, that the dollar index has been so well behaved. If I didn't know better I'd say there might even be some collus…. er….. coordination between the world's monetary authorities.
Draghi may yet get what he wants from the Euro as bond yields on the continent continue to make new lows. Spain's 10 year bond hit 2.6% last week, a level that is barely above the U.S. rate at 2.59%. Given a choice between buying Spanish bonds or U.S. bonds at the same rate, I can't help but think that most rational investors, even European ones, would choose the U.S. dollar version - especially with the ECB publicly stating its desire for a cheaper currency. With Japan providing no competition for global bond assets (their 10 year yields a paltry 0.6%), the hands down winner in the global developed bond market rate competition would appear to be the U.S. Treasury.
That assumes, of course, that currency values are determined by interest rate differentials, something that is widely believed but hard to square with the available historical data. Rates do matter at some point, but one would probably be better advised to buy currencies based on expectations of economic growth. If the ECB's monetary easing is successful in raising the growth prospects of Europe, stocks there seem likely to attract a bid (not that they've been lacking for buyers; European stocks are up 160% from the lows). That might derail Draghi's plans for a lower Euro if the demand for European stocks outstrips the demand for bonds.
It might also depend on the effectiveness of the newly announced policies, something that is far from assured. Like the U.S., Europe's growth problems are mostly structural and potentially impervious to more monetary easing. And certainly, Japan's experience with unconventional monetary policy would not seem to provide any reason for optimism about its ultimate effectiveness. They've been trying for over two decades to escape the malaise of poor demographics, high taxation and a coddled corporate culture through monetary pumping, only to find themselves deeper in debt and still searching for consistent growth. Notably, the lack of growth and the lowest interest rates in the world hasn't been conducive to a cheaper yen (until recently) and Draghi may find himself facing the same conundrum.
Indeed, there has been a plethora of research released over the recent past suggesting that too easy monetary policy is itself causing the very deflationary tendency it is designed to combat. The Minneapolis Fed chief, Narayana Kocherlakota first mentioned the possibility way back in 2011 but quickly backed off. The St. Louis Federal Reserve's Stephen Williamson published a paper last November arguing that the Fed's purchase of so many Treasuries was actually pulling down inflation rates. Last but not least, the Bank for International Settlements (the central banks' central banker), taking a longer term view, said recently that the world's addiction to monetary stimulus may be expansionary in the short term but contractionary over the long term as it just steals growth from the future. Reading through this research last week left me with a queasy feeling that, after 5 years of coordinated theft, we might soon be arriving at the dreaded long term where the future doesn't require shades.
One should not doubt Draghi's commitment to the easing path though. Draghi told reporters after the ECB's actions:
Are we finished? The answer is no.
Draghi's MacArthuresque approach to monetary policy (or Terminator approach: "I'll be back") is somewhat surprising given the mounting evidence that it has not only been ineffective in the U.S. but is also causing some agita among U.S. Fed officials. Jon Hilsenrath, the Fed's preferred mouthpiece, published an article in the WSJ last week outlining their growing angst about the lack of fear among market participants. The lack of stock market volatility and narrow spreads in the bond market are increasingly being seen as evidence that investors are taking on more risk than they can ultimately stomach due to the Fed's repeated assurances about keeping future interest rates low. One does wonder sometimes if the Fed really thinks through the consequences of their actions. QE was, according to Ben Bernanke himself, intended to entice investors to take more risk. Maybe the Fed should have a Bible on hand at FOMC meetings so they can review those passages about reaping what one sows.
Something that should further worry the Fed is another effect of the lack of volatility. Banks and brokers have seen trading revenue drop precipitously over the last year as bonds, currencies and other assets' volatility has subsided. Trading desks are going through their own little depression right now as Wall Street layoffs are ramping up as earnings from trading are ramping down.
Combined with the reduced risk taking measures mandated by Dodd Frank, the lack of volatility is reducing the capacity of the banks and brokers. What happens at the point where investors suddenly wake up and realize that corporate and junk bonds ought to offer a bit more yield protection? What happens when they sell those oh so convenient ETFs trading corporate and junk bonds and leveraged loans? Who exactly is going to step into the breach and be the buyer? Certainly not Wall Street banks and brokers. They don't have the balance sheet capacity, the regulatory permission or the people to absorb the volume of bonds produced in the last few years should buying suddenly turn into selling. The Fed might want a bit more volatility but they should probably be careful what they wish for; they might get it.
What Mario Draghi learned last week and what the Fed is learning - ever so slowly - is that markets and economies don't always act the way the central bankers and their beloved models think they should or would like. Draghi announces measures designed to weaken the Euro and traders react contrary to his desires by pushing the Euro higher. The Fed asks - insists actually - that investors take more risk and are surprised that investors are taking on more than they had prescribed. The evidence that the unintended consequences of too easy monetary policy are greater than the preferred and intended ones is piling up. Volatility, like Mario Draghi and Douglas MacArthur, shall return. It will be interesting to see how the Fed and other central banks react when it does.