Without QE, “Eurozone Financial Markets Would Collapse”

By Wolf Richter: The euro dropped to $1.16, the lowest since 2005. The ECB has imposed negative deposit rates on Eurozone banks, which are passing them on to their depositors. The ECB will flog savers until their mood improves. It has flooded the Eurozone with liquidity whose excesses are sloshing audibly through the system.

Despite the Eurozone’s economic issues, stocks have soared in recent years. As have government bonds. The German 5-year yield is negative; the 10-year yield dropped to 0.41%. Forget France’s beleaguered government and economy, and the downgrades of its credit rating: its 10-year yield is 0.67%; its 2-year yield is negative. Spain’s 10-year yield dropped to 1.49% before edging up a little. Italy’s 10-year yield fell to 1.70%. These countries are borrowing at practically no cost.

Since 2011, the Eurozone’s current-account surpluses with the rest of the world have risen sharply, approaching 4% of nominal GDP, despite the debt crisis and even while the euro was very strong. The November trade surplus, reported today, jumped to €20 billion, up from €16.5 billion a year ago.

And it’s precisely this environment that the ECB wants to douse with even more liquidity by buying large quantities of government bonds to force interest rates down even further and devalue the euro even more. Because now it would suddenly heal the various problems each of the 19 Eurozone countries might have.

The decision will be announced after its meeting on January 22. It’s not like the ECB hasn’t tried similar things before. It already owns a ton of Greek debt that no one else wanted. It is already buying asset-backed securities and covered bonds. It has been lending banks essentially free money that they then use to buy government bonds. These machinations have been going on for years.

But under the new deal, the ECB would balloon its balance sheet to €3.1 trillion from €2.2 trillion by buying government bonds. It’s actually the old deal, lovingly dubbed Outright Monetary Transactions, announced in 2012 after Draghi’s “whatever it takes” pledge. But OMT ran into legal hurdles that remain unresolved. The ball is currently in the European Court of Justice before it bounces back to the German Constitutional Court. At issue: national sovereignty and the treaties that formed the EU.

But the word “deflation” has been thrown around with great passion to describe what amounts to mild inflation with the first tiny dip in years into deflation due to plunging energy prices. Core inflation remains positive. It’s just that folks in the Eurozone pay less to other countries for their fuel – which acts as a stimulant to the Eurozone economy.

“The risk of deflation is just a pretext for quantitative easing, for hammering out a bailout program for southern Europe,” Hans-Werner Sinn, head of Germany’s Ifo economic institute, told Bloomberg in his politically incorrect manner. The decline in inflation is due to lower crude prices, and “there’s no need for ECB action,” he said, pooh-poohing the entire concept.

Printing money to buy government bonds increases the risks for the Eurozone’s unity since it might violate the German Constitution, Sinn said. And Germany might be constitutionally bound to leave the Eurozone. “Somebody would have to give in, and that would be the ECB,” he said. “It would have to give up on OMT voluntarily.”

But financial powerhouses in Europe and on Wall Street have been clamoring for it, especially now that the Fed has stopped handing money to them. They want more, and the ECB will have to produce it.

The Royal Bank of Scotland, for example. Rather than increasing its €2.2-trillion balance sheet to €3.1 trillion, the ECB is planning to increase it to €4.5 trillion, RBS wrote in a paper fed to the media this week. This would amount to €2.3 trillion in additional QE, more than twice the amount ECB officials have bandied about.

Regardless of any legal challenges or opposition in Germany, “Large scale QE is coming imminently, on 22 January,” RBS said. “Waiting until March – something we have been asked many times – is just not feasible….”

The message: QE would cause bonds, stocks, and other assets to inflate further. So buy, buy, buy.

Now Natixis, the asset management and investment banking division of Groupe BPCE, the second largest bank in France – an institution that last July finally discovered the “Redistributive Effects” of QE – jumped into the debate.

QE would lead to “absurd financial asset prices,” its report said. Risk premiums would get squeezed further, interest rates would dive deeper into the negative. But the expectations of QE have already been baked into asset prices since markets “have been convinced since the summer of 2014” that “normal” QE would arrive by 2015. Hence, the devaluation of the euro, the plunge in long-term interest rates, and the evaporation of risk premiums.

This expectation by the markets, propagated by the big players, most recently by RBS, acts like a gun to the ECB’s head:

If the ECB announces today that it will not implement quantitative easing, Eurozone financial markets would collapse: rise in interest rates, fall in the stock market, and widening of credit spreads.
Accordingly, the ECB cannot refrain from implementing quantitative easing, since it definitely does not want financial markets to collapse.
But this situation could last: quantitative easing may be ineffective; the financial markets would then expect larger-scale quantitative easing (€1.5 trillion to €2.0 trillion), which would force the ECB to implement it.
The ECB is therefore a prisoner of financial markets’ expectations.

Instead of stimulating the economy, QE would boil down to a “disguised form” of monetization of government debt “to improve governments’ fiscal solvency.” And since interest paid by the government to the central bank is paid back to the government, it is “equivalent to a cancellation of the public debt bought by the central bank.”

QE would create “major tensions” with Germany. And it would “undoubtedly” drive some Eurozone countries “to take advantage of the monetization of their public debt to avoid reducing their fiscal deficits.”

Alas, since the financial markets are already baking this into prices, the ECB will have to follow through while dressing it up in nice verbiage. No central bank (even if it were so inclined) can stand up to what banks and big financial players are clamoring for, regardless of the ultimate costs to the economy, or society as a whole. They want more, they get more. It’s just that central banks might occasionally take turns in providing it.

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