As of last week, the European Central Bank's balance sheet exceeded $3.96 trillion. This represents about a third of the eurozone's GDP of $12 trillion and is 30% larger than Germany's GDP of nearly $3 trillion. The U.S. Fed's balance sheet is $2.9 trillion.
So far, about 35% of this balance sheet represents the ECB's lending to European banks, many of which would be insolvent without the ECB's help. In addition, a significant portion of the balance sheet represents sovereign debt of countries with financial issues such as the PIIGS. This supports the idea that the ECB's gigantic balance sheet may be full of low-quality debt.
The ECB's easy money helped the market rally in the short term, however this poses a very dangerous threat to the continent's economy in the long term. First of all, if banks and sovereign nations get habituated to "free money," they might postpone or even cancel some of the much-needed reforms expected from them. Second, if the balance sheet of the ECB "blows up," European tax payers will have a huge debt to pay off, which is more than 10 times larger than the much-feared debt of Greece. Third, the ever-expanding balance sheet of the ECB may trigger inflation in the eurozone in the future as the value of the euro depends on the the world's confidence in the health of the eurozone.
If the ECB runs out of ammo, this may pose a threat to the debt of European countries, particularly Spain and Italy. Last year, these two countries saw their debt yield skyrocket to unsustainable levels, and the ECB's massive help brought the yields to more manageable levels. In the chart below, you will see Italy's 10-year bond yield for the last year. As you may remember, when the ECB's cheap money lending to banks was announced, Italy's 10-year bond yield was above 7% and currently it's below 5%. If the ECB's cheap lending mechanisms stop, Italy's bond yields might jump back up again.
In the chart below, you will see the same pattern in Spain's debt. I would bet that a lot of the ECB's cheap lending was spent on buying Italian and Spanish debt.
Implications for Investors
- Investors should stay away from European sovereign bonds as their yields have bottomed, prices have rallied. They are too expensive and too risky at this point.
- Investors holding cash in euro currency might want to diversify their cash portfolio with other currencies such as the U.S. dollar, Japanese yen, Swiss franc and gold (NYSEARCA:GLD), (NYSEARCA:IAU).
- European debt problems will continue to dominate headlines for a long, long time. Include some defensive stocks in your portfolio, such as BP, ExxonMobil (NYSE:XOM), Pepsi (NYSE:PEP), Coca Cola (NYSE:KO), Intel (NASDAQ:INTC) and P&G (NYSE:PG) to protect your portfolio from euro-based volatility if you haven't already.
- Keep some cash aside in case this whole thing blows up. There will be many stocks with good valuations to buy if or when that happens, although I believe that governments have the ability to kick cans down the road for many years.