God is a Capitalist

Wednesday, January 28, 2015

Big EZ's QE Fail

The stock market climbed last week in anticipation of the European Central Bank's announcement of its program to purchase more bonds. The US press has dubbed it the ECB's quantitative easing, or QE. As with the several versions of QE in the US, the ECB's purpose is to reduce interest rates enough to persuade businesses to borrow and expand and consumers to borrow and buy cars and houses. Also, the bank hopes it will ramp up price inflation that will reduce debt.

The bank's QE effort will fail to achieve the goal as did those of Japan and the US. ECB president Mario Draghi admitted as much when he told politicians that credit expansion alone will not rescue Europe without "structural" changes by governments. In other words, Europe's problems are microeconomic, not macro. The structural changes needed include reducing taxes and rolling back regulations, especially rigid labor regulations that make it almost impossible for businesses to divorce employees. Businesses are not investing in the US because of high taxes and job-killing regulations, but the problem is much worse in Europe.

Another reason it won't work is a micro factor known as margin compression at banks. Banks face fixed costs in loan generation that require sufficient profits to cover. As a result, bank interest rates for business and consumer loans are much higher than the risk free rate on government bonds. The ECB may be able to reduce rates on government bonds, but due to costs, banks will not be able to reduce interest rates to borrowers. Also, Basel banking regulations punish banks for lending to businesses and consumers by requiring higher reserves for such loans compared to loans to governments and for real estate.

The move by the ECB has lowered the value of the Euro with respect to the dollar and that will help exports in the short run. The US and the Big EZ (Euro Zone) are the largest trading partners of each, which means the Big EZ wants to sell more to the US and buy less. That will hurt US exports and reduce US GDP in the short run. But the benefits will be short-lived. Imports will cost more in Europe while increased exports will reduce the domestic supply of those goods and raise prices. Within a year rising prices in Europe will make their exports more expensive and undo the advantage that a lower Euro provided.

At the same time that QE helps debtors, any price inflation it causes will hurt workers by slashing the real value of their wages. And lower interest rates cut the incomes of the retired and others on fixed incomes. Inflationary policies always hurt more people than they help. But don't expect mainstream economists to ever admit that. Mainstream economists are like politicians: they take credit for everything good that happens under their policies and blame others for failures. Or they fall back to the shelter of the claim that "things would have been worse."

The German 10-year bond is yielding a mere 0.39%. Italy pays 2.51%; Greece 8.98%; Spain 1.35% and Ireland 1.16%. So if the ECB wants to get the biggest bank for its buck it will have to buy Italian and Greek debt. Greece is unlikely to default on its debt because other Big EZ nations have guaranteed it. The biggest risk to Greek and Italian bond holders is higher interest rates, but that threat is not likely for the next year as the ECB's QE program continues. Those brave enough to buy Greek debt will likely enjoy high yields with good principal appreciation as a result of ECB buying the debt.

The strengthening dollar poses another threat to investing in the Big EZ. As the dollar climbs against the Euro it diminishes returns from any investment in a Euro denominated asset, such as Greek bonds. No one can predict the day the dollar will turn around, but it will eventually. That day may come when the US economy tumbles into recession. Or it may happen when the ECB’s money printing machine loses its effectiveness. Keep in mind the microeconomic principle of diminishing marginal returns. The printing will generate its largest impact in the first few months and the remaining months will prove useless or even damaging. So investors face a tradeoff between locking in high rates now and enjoying principle appreciation vs. erosion of those earnings through currency depreciation. The good news is that when the dollar does fall from the heavens the currency risk will turn into a currency bonus: investors will be able to add to their returns the benefit of the Euro appreciating against the dollar.  

The problem with buying Italian and Greek bonds is that the funds that carry them aren't listed on Schwab, ETrade or Scottrade. The best investors might be able to do is buy a heavily diversified fund that includes and small amount of Italian and Greek bonds.

No comments: