Europe And The Central Role Of Central Banks

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Includes: ADRU, DBEU, DBEZ, EEA, EPV, EURL, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEU, HEDJ, HEGE, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, SBEU, UPV, VGK
by: Nadex

Summary

The ECB has just shown that central banks can act when governments can't, and in doing so, may have increased the role of monetary policy versus fiscal policy.

Worldwide, fiscal policy has been largely ineffectual, not so much because government efforts have failed, but because most governments have failed to make an effort.

While many traders and investors focus on short-term market movements, all good traders know they must watch the larger time-frame players, who drive big trends. In Europe, that's the ECB.

By Vikram Rangala, Nadex

Global stock markets appeared to reject and then cheer yesterday's ECB policy announcement of more stimulus and reduction of borrowing costs. While some lament the limits of monetary policy to restore inflation and growth, the ECB just asserted that central banks are the only ones who can. It also may have set a course for the euro and Europe for the rest of the decade.

Yesterday, most financial media declared that the morning plummet (300+ points in the Dow) was the market's judgment of not just Mario Draghi's announcement, but even his overall job approval. What was so bad? The stimulus was great, the lowering of interest rates even further below zero was fine, but investors were allegedly bothered by Draghi's hints that there would be no more of one or possibly either.

What a difference a day makes. Stocks rallied after the big drop, from a familiar support level, and have continued to rise today. What's more, the volume during the plummet was light, whereas today's rise has strong market participation. Draghi hasn't done anything since yesterday, yet an article in today's Bloomberg.com begins, "The European Central Bank's stimulus package isn't that bad after all."

Quantitative Easing Isn't Easy

The ECB's policy announcement included a reduction in borrowing costs and an expansion of the central bank's quantitative-easing. Earlier QE had been restricted to buying bonds issued by various European governments. The new round expands the bond-buying stimulus to include purchases of selected corporate bonds. While you could see that as a vote of confidence in European business and even a kind of investment in it, it also hides a more sobering fact: there just isn't that much more debt for the ECB to buy.

With the end of that avenue in view, it was an added shock when Draghi stated that he didn't anticipate cutting interest rates further, either. When the ECB lowered rates below zero for the first time, it entered uncharted territory. No one really could say how low a central bank could go, especially this one, which has a Europe-ful of economies to look after. Draghi's announcement that this rate would be the lowest set a precedent without really giving an explanation.

On the Nadex exchange, the most popular binary option in 2015 and so far this year has been the EUR/USD, which topped all major stock indexes in volume traded. Like most forex and futures traders, Nadex binary option and spread traders are focused on short-term market movements. However, all good traders know they must be aware of the larger time-frame players, those who are driving the longer-term, overall movement.

Where the euro will go is still uncertain, but we now know that the main force driving the euro and Europe for the next few years will be monetary and not fiscal. That goes for the rest of the world, too. Central banks are more central than ever.

The New Centrality Of Central Banks

Central banks weren't always such major players in economic recoveries. That changed in the early '80s when Fed Chair Paul Volcker raised the Fed Funds rate to 19.1% to curb inflation. Some point to Ronald Reagan's tax cuts, mainly for the wealthy and corporations, as the reason inflation was tamed. But Reagan also approved six tax increases, raised the deficit, increased unemployment over 10% and presided over a recession during his term. Fiscal policy and monetary policy were not actively coordinated in the '80s and were in some ways at odds.

The same may be true three decades later in the US, Europe, and in most Asian countries. The only exception may be India, where RBI President Raghuram Rajan has been able to keep interest rates high even though lowering them would probably help boost the government's approval ratings. Worldwide, fiscal policy has been largely ineffectual, not so much because government efforts have failed, but because most governments have failed to make an effort.

In the US, the Congress has now voted 70 times to try and repeal the popular Obamacare reform while failing to pass significant measures to stimulate wage growth or infrastructure investment. Europe's government is about as well coordinated as Draghi's native Italy, with countries like Spain, France, Greece, and Italy close to their legal deficit limits trying to work with nations like Germany that can afford to spend more but have promised voters they won't. China and Japan face not only stagnation, but also growing evidence of massive corruption.

With governments flailing and feckless, undemocratic central banks are the only ones who seem able to act. Last week's measures announced by the People's Bank of China calmed investor worries. The meetings next week by the U.S. Federal Reserve, the Bank of Japan, and Bank of England are all going to be watched closely as well.

But by effectively declaring what the economic landscape of Europe will look like through the end of his term in 2019, Mario Draghi has given those other banks only two choices: risk-taking measures that will inevitably be weakened by non-cooperation from Europe, or do their best to work with the QE and negative interest rate policy of the ECB.

What's good for Europe - if indeed it is good for Europe - is going to have to be good enough for the rest of the world as well.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.