As I noted in a previous article from this past weekend, Germany has been strongly opposed to guaranteeing the debt of other Eurozone countries through so-called Eurobonds. With a full EU summit scheduled to take place this Thursday and Friday, German Chancellor Angela Merkel has been clear that Eurobonds are a non-starter for Germany. As this article in Businessweek notes, Merkel is using the argument that joint liability would violate the German constitution:
Merkel, speaking to a conference in Berlin today as Spain announced it would formally seek aid for its banks, dismissed "euro bonds, euro bills and European deposit insurance with joint liability and much more" as "economically wrong and counterproductive," saying that they ran against the German constitution.
The constitutional argument is actually quite a clever strategy for Merkel to employ. It's one thing for other Eurozone countries to state that Germany is protecting it's own selfish interests; however, it's much more difficult to attack a country for arguing that a particular course of action would violate their constitution.
Unfortunately for the Eurozone, while the political discussions continue to drag on, the market is providing an increasingly strong no-confidence vote on Club Med debt. Let's take a brief look at the interest rates Spain is currently paying on their sovereign debt. I pick Spain because they are the linchpin of the Eurozone crisis - if Spain blows-up, Italy will almost certainly follow, and this might even lead the markets to attack France. Although there has been a slight drop in Spanish debt yields recently, assuming the upcoming EU summit deadlocks, they will almost certainly soar above 7% again.
Assuming Germany will never agree to any kind of debt mutualization - at least in the short-term - is there anything that Europe can do to ease the crisis, at least temporarily? Given the current political constraints, I believe that the only way for Europe to contain the crisis is for the ECB to implement a massive Quantitative Easing (QE) program. The ECB should announce it's intention to buy unlimited amounts of Eurozone sovereign debt, with a focus on debt issued by Spain and Italy. Spain and Italy are particularly critical, as they are both too big to fail yet too big to bail out as well.
A massive and unlimited ECB QE program as described above would quickly have three beneficial effects:
1. First, it would drive down the interest rates of sovereign debt across the Eurozone, particularly from Spain and Italy;
2. Second, it would send a strong signal to the markets that the ECB is committed to protecting Spain and Italy, and that short bets against these countries' sovereign debts are a losing proposition;
3. Finally, it would provide time for leaders to develop a longer-term solution to the Eurozone crisis. Generally speaking, politics and markets work on quite different timeframes, and the ECB needs to buy time for Eurozone leaders to agree on a solution that will involve some very complex economic and political tradeoffs.
Let me add that I would actually differentiate between QE in the US and QE in the Eurozone. The main purpose of QE is to drive down long-term interest rates to encourage borrowing and investment in the economy. Looking at the chart below, US interest rates are already near 10 year lows, and I really doubt that additional QE by the FED will do anything but provide a temporary sugar boost to stocks and other risk assets.
In regard to the ECB, however, I believe QE is well warranted, as its entire purpose would be drive down Eurozone bond yields. Ambrose Evans-Pritchard had an excellent article in the Telegraph recently, where he also argued that QE was the only way to contain the crisis. The article had a good quote about Nomura that accurately summarizes the argument for QE by the ECB:
Nomura said the ECB must act with overwhelming force rather than engaging in piecemeal bond purchases that fail to restore confidence and have the toxic side-effects of pushing existing bondholders down the credit ladder -- the dreaded effect of "subordination".
I see QE by the ECB as a middle ground between doing nothing and actually reaching a politically fraught agreement on Eurobonds. While we cannot be sure what will come out of the upcoming EU summit, I believe it is certainly within the realm of possibility that Eurozone leaders will indicate that it is acceptable for the ECB to implement QE.
Let's take as a hypothetical that the ECB implements QE. What would be the investing implications of such a program? I see three main possibilities:
1) We could expect European stocks to soar. In this case, any European stock ETF should benefit. Both the Dow Jones EURO STOXX 50 ETF (FEZ) and the BLDRS Europe 100 ADR Index ETF (ADRU) are both good choices. For more targeted exposure, I think Spanish and Italian stocks would soar in the mother of all relief rallies. In this case, the iShares MSCI Italy Index Fund (EWI) and the iShares MSCI Spain Index Fund (EWP) are the correct choices.
2) I believe the Euro itself would also stage a rally, in which case the CurrencyShares Euro Trust ETF (FXE) would be the choice. Alternatively, if we assume that the Euro would rally against the dollar, then the PowerShares DB US Dollar Index Bearish ETF (UDN) would work, as the majority of its holdings are in long Euro/short dollar positions.
3) On the bond side, the WisdomTree Euro Debt Fund (EU) should also rally in relief to ECB Quantitative Easing. If you are feeling really bold, the PowerShares DB Italian Treasury Bond Futures ETN (ITLY) offers pure exposure to Italian debt and should also rally strongly.