Both the Fed and the European Central Bank (ECB) disappointed investors this week by not taking additional monetary action. So why did investors yawn when the Fed declined to answer investor hopes for an extension of monetary easing, but sold aggressively when the ECB failed to take action?
Part of the response can probably be blamed on Mario Draghi, the president of the ECB, who set investor expectations too high last week. After pledging to do “whatever it takes to save the Euro,” Mr. Draghi and the ECB failed to produce any immediate follow through.
But there is another reason the market took the ECB disappointment much harder than the Fed’s: the ECB can still impact the health and stability of the European economy, while there is little left for the Fed to do.
While the Fed may ultimately decide to extend the United States’ asset purchase program, it is unlikely to have much impact on the US economy. Whether the Fed decides to buy Treasuries or mortgage-backed securities, both the yield on the 10-year Treasury and the rate on a 30-year conventional mortgage are already at record lows. Pushing down mortgage rates from 3.50% to 3.0% is unlikely to spur a housing recovery as long as consumers are still overleveraged and scarred.
The Fed could theoretically take more aggressive actions, such as trying to spur banks to lend more. However, the lack of credit growth in the United States is arguably more to do with a lack of demand than of supply. In short, most of the mechanisms by which the Fed can impact the real economy are already depleted. While another round of quantitative easing (QE) would probably lead to a rally in risky assets, the impact of these rallies is proving ever more fleeting. Another round of QE is unlikely to be substantial enough to produce any real bump to either confidence or consumption.
On the other hand, there is much the ECB can do. Spain and Italy are facing ever rising borrowing costs, which are now reaching a level that necessitated bailouts in Portugal, Greece, and Ireland. In addition, the European banking system is still vulnerable to a run. Whether through a resumption of their Securities Market Program (SMP) or through granting a banking license to the European Stability Mechanism (ESM), there is much the ECB could do to lower European borrowing costs and provide time for structural reforms.
Furthermore, if a banking crisis is to be avoided, the ECB will need to push more aggressively for a more integrated European banking system and a European-wide deposit insurance scheme.
Neither the Fed nor the ECB can solve the broader problems plaguing Europe and the United States. In the United States, consumer deleveraging needs more time. Whatever help Washington can provide is unlikely to come from the Fed, but needs to come from the federal government. In Europe, the hard work will fall to the governments to implement structural reforms and arguably more fiscal union. That said, the ECB can provide time; this is what the market was looking for and what the ECB failed to provide.
In the meantime, I continue to advocate underweighting Italy and Spain, which look cheap for a reason. I do like some countries in more economically stable northern Europe and I especially like Germany, which has stronger economic fundamentals than its eurozone counterparts.
Investors can access the northern European countries I prefer through the iShares MSCI Germany Index Fund, (EWG), the iShares MSCI Netherlands Investable Market Index Fund (EWN), and the iShares MSCI Norway Capped Investable Market Index Fund (ENOR).
Disclosure: The author is long EWG
Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country may be subject to higher volatility.