August 7, 2012
In the past few days, financial markets have become obsessed with whether or not the central banks of the world will cut interest rates, and print more and more money. This obsession was obviously heightened by the comments of ECB president Mario Draghi last week, when he said he would do “anything” necessary to save the euro.
“Anything” was taken to mean that the ECB would buy the bonds of Spain, and possibly Italy, directly. In short, it would do what the Germans feared most: monetise sovereign debt simply by printing money to buy the IOUs of peripheral governments. As a result, traders thought that they had been given a type of insurance policy because they knew the ECB would buy bonds of countries like Spain and Italy. This pattern is not new.
Over the past year, every time there is a word from a central banker about cutting interest rates, the financial markets rally. This is what has come to be known in the market as the ‘risk on’ trade. In other words, the trader can take risky positions if the central bank is behind him. The risk is ‘on’.
If the central banks don’t deliver, the financial markets sell off. This is known as the ‘risk off’ trade.
We are getting to a stage where the financial markets are now addicted to the central banks’ infusion of money. But we are also in the position that the central bankers are looking over their shoulders at the reaction of the markets all the time. If the markets sell off, the expectation is that the central bankers will react and the expectations are heightened which, in turn, has the effect of backing the central bankers into a corner, as Draghi saw last week.
Draghi said he would do “anything” to save the euro. Then he did absolutely nothing, bar a ham-fisted press conference last Thursday which made things worse. Now the crisis in Spain and Italy has been exacerbated by inaction. And we start the game again at lower prices and higher bond yields.
This game of cat-and-mouse has come to dominate the eurozone landscape. But it’s not fixing anything because, all the while, the euro – or at least the operation of the euro in different countries – has become more and more dysfunctional. Member countries face vastly different interest rates – a situation which can’t go on.
What is the point of a central bank of a currency zone that can’t set interest rates in that zone properly?
But due to the political nature of the project, it looks like the euro will limp on with totally different monetary conditions in the various parts of the union. These will amplify the recessions in the periphery and could well lead to, wait for it, property bubbles in the core. Yes, property bubbles.
The prospect of a property bubble in the core fuelled by incredibly low interest rates should make us consider the point of all this central bank credit, and whether it is a viable long-term solution. As a short-term tactic, it may make sense in a crisis, but longer-term rising asset prices – whether they be real estate, bonds or stocks – can only be sustainable if the underlying economy generates a robust growth rate, which in turn drives profits.
Can this be achieved by the central banks printing money? In other words, can central banks eliminate risk? And if central banks can eliminate risk at will, then what’s all the fuss about?
The idea behind the markets’ central bank obsession must be that printing money can obviate market risk. It cannot.
Consider what is happening in Europe now. There are two primary reasons we’re seeing so much attention focused on the Draghi debt monetisation ‘solution’ to the economic crisis.
The first is that austerity doesn’t work. It makes an economy shrink, and therefore undermines that economy’s capacity to service its debt. Spain is a very good example of this right now, as is Greece. All over the periphery, each time an economy splutters because of cutbacks, the reaction of finance ministers is to promise deeper cuts. This reinforces the crisis, growth stalls and default risk rises, propelling bond yields higher.
The second reason for stubbornly high bond yields is that policy-makers are refusing to countenance default. This default option burns bondholders, but is much more effective at getting economies back on their feet again. The reason it is more effective in getting the economy back motoring is that, after a default, new capital is no longer sucked into subsidising old mistakes, as is the case now.
Because of austerity, which isn’t working, and the “there’ll be no default” position (with the exception of Greece), there is only one solution to the European debt crisis – and that is to print more and more money, buying up more and more debt directly.
However, such a policy of opening up the balance sheet of the ECB directly puts the ECB on a collision course with the Bundesbank, its most important constituent member. The Bundesbank believes that central banks can’t obviate risk. In fact, the German view is that, the more money that is printed now, the more risk is built into the system in the guise of potential inflation.
It also believes that all this money will need to find a new speculative home, which in Germany looks likely to be a property bubble. The Financial Times recently reported that a house in Munich which cost â‚¬3 million six years ago, changed hands last month for just over â‚¬6 million. Remind you of somewhere?
If Draghi wants to preserve the euro, urging governments to stick with austerity while not countenancing some sort of default in Spain, he will have to buy peripheral bonds. This sets him directly against the Germans.
The reason he backed down last Thursday, and didn’t do what he had promised, was because he couldn’t bring the Germans with him. The markets, which are used to instant gratification, sold off – and the risk trade is off.
Over the next few weeks, we are going to see a battle for the heart and soul of the euro, in which there can only be one winner. Who said central banks could eliminate risk?