All Aboard!

The ECB has boarded the Quantitative Easing train.  Perhaps the deflation that is stalking Europe finally prompted the move. Mr. Draghi and the ECB board have had the benefit of observing Fed policy and Bank of England policy working, versus the extended obstinacy of the Bank of Japan and its sub-optimal results. Parts of the eurozone have a similar financing problem to the one Japan had, enormous and growing stocks of government debt combined with high real interest rates.  They also have problems that Japan does not, limited control over monetary policy and limited domestic financing. Hopefully, Mr. Draghi’s kind offer to buy €60 billion of bonds a month from March of this year through September 2016 and beyond will be enough to spur inflation and some animal spirits.

This move marks the end, for me, of the peripheral tightening trade. Spanish, Italian and other peripheral country spreads may tighten further, but is it worth holding on at these yield and spread levels?  These are sovereign credit spreads, not interest rate differentials between countries with independent monetary policies. They reflect default risk, not relative inflation rates and comparative position in the macroeconomic and monetary cycles. The last time people believed that these credits were equal to those of the Germanic countries it didn’t work out so well. Responsibility for these debts will still largely reside with their issuers. The eurozone, taken as a whole, will only assume 20% of the responsibility for the purchased debt. Had they moved to full mutualization (collective responsibility) peripheral yields would have converged nearly to the German yield.

The EUR should continue to weaken, though probably not at such a torrid pace.  If it is not already, it will become a preferred funding currency; market players will borrow it to fund higher yielding investments elsewhere.  This is an attractive proposition, because negative EUR interest rates mean that you are paid to borrow the currency, at least if you do so via FX forwards. As with all carry trades, there will be the danger of sudden reversals, but US and European monetary policies will be trains headed in opposite directions for the foreseeable future, making the strategy a reasonable bet.

Some background:

Inflation in the four largest eurozone economies is close to, or below, zero. The fall in the oil price will reinforce this trend as will anemic economic activity.

EU inflation

The lackadaisical reaction of European policy makers to their debt crisis is similar to that of Japan’s policy makers to theirs. European money growth since the financial crisis bears an uncanny resemblance to Japanese money growth in the early years of its crisis. I arbitrarily set the dates for each series to begin a year prior to crisis inception as a first pass and, voila, no further adjustment was needed!

EU&JP money

Beside its slow response to the crisis, Europe has unique, albeit self-inflicted, problems. European countries volunteered to be in a fixed exchange rate system where adjustment must flow through inflexible real economies, i.e., the goods and services sectors. Labor and goods markets are thoroughly tied up in red tape.

This has left countries like Spain, France and Italy gasping for air.  Though their interest rates have come down, debt is piling up because their growth rates are lower still.  Debt growth depends on a country’s interest rate relative to its growth rate, among other things.

Here we have Spanish nominal GDP (NGDP) growth versus its 10 year bond rate. To do this properly you want to compare nominal or real (inflation adjusted) quantities to one another; don’t mix them. Since mid-2008 Spain’s GDP growth has been well below its interest rate.  Debt has been growing.  Spain, I should mention, is one of the few countries that have enacted economic reforms, which may be why its NGDP is on a rising trend.


It also helps that our Mr. Draghi was able to con(vince) European bond market players that the yields of peripheral country bonds, like Spain and Italy, should converge towards those of Germany.

Italy really could use some help. Rates have fallen, but GDP growth in in a slump. Hopefully QE will provide some relief.


The US got this right.  The Fed’s actions have helped suppress interest rates and keep nominal GDP above those rates. This is called “Financial Repression”; it is one of the few ways to successfully reduce a sovereign debt overhang.  It is not clear to me that this outcome will ever be within the reach of the European periphery due to the way the eurozone is currently constructed.  Credit risk within Europe is alive and well.


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