Divergence in ECB and Fed rate regimes will drive portfolio shifts

The big news today was the ECB’s decision to lower interest rates 10 basis points to 0.05% and its simultaneous decision to engage in a form of quantitative easing using the asset-backed market as a vehicle. While these measures are welcome, they will almost certainly not be enough on their own. But it will give some respite to a euro area on the brink of outright deflation.I have a few brief comments below.

These kinds of decisions are commented on copiously so I am not going to spill too much ink on this until we know more details about the ABS program. Interestingly, I was in an email thread with a number of euro watchers and euro experts this morning before the decision and we were collectively discussing an article in Der Spiegel, which depicted Merkel as increasingly isolated on austerity in Europe. The key was the discussion about fiscal versus monetary policy effectiveness, which I will lay out. But here’s a bit of the what Spiegel was saying:

The debate over Germany’s insistence on euro-zone austerity has flared anew as an ailing France continues to demand economic stimulus. The European Central Bank may now be siding with Paris, leaving Merkel looking increasingly alone.

[…]

Among the ruling Socialists, many believe the blame for France’s current troubles doesn’t lie mainly with themselves and their unwillingness to push through structural reforms. Rather, they blame Germany’s austerity policies in Europe. Indeed, the only disagreement among the French left is the question as to how loudly they should voice their displeasure. In a sense, it is that question which resulted in last week’s fall of the French government. It tripped over Merkel.

French President François Hollande released his cabinet last Monday largely because Prime Minister Manuel Valls wanted to finally rid himself of his left-wing critics, Economics Minister Arnaud Montebourg first among them. Montebourg had loudly complained of European austerity and demanded that the French government cease taking heed of the “obsessions of the German right.”

The Money Pump 

The result: France now has a government that is more clearly than ever in favor of reforms. But at the same time, Hollande is seeking to increase pressure on Germany to fundamentally rethink its economic approach for the euro zone. He wants to convince Merkel to loosen the stability criteria. Last week, he even demanded a special EU summit to agree on measures to promote economic growth. In France, that has traditionally meant pumping more state money into the economy.

In essence, the dispute focuses on the question that has divided Europe since the beginning of the euro crisis. The Chancellery in Berlin has demanded that EU countries in crisis undertake far-reaching structural reforms coupled with biting austerity programs. Paris, meanwhile, has been the voice of those asking that the stability pact be made more flexible to make room for economic stimulus, with reforms coming later, if at all. Until recently, the two camps had been roughly equal in strength within the EU. But recently, Paris has unexpectedly won over new allies.

New European Commission President Jean-Claude Juncker has joined Hollande and Italian Prime Minister Matteo Renzi in promoting a flexible interpretation of the stability pact rules. The US government and the International Monetary Fund likewise support the position.

Plenty of outside experts agree… 

There’s a lot more to the article. So I highly recommend reading the full article. I agree with the gist of the article. The tide has turned against the Germans. The Finns and the Dutch are having their own problems and the French and Italians are basically in recession. There will be compromises. However, the compromises we are likely to see because of this will not be enough. Only when the Germans themselves feel the pain, will the tide turn demonstrably. There is a lot more pain to come.

Now, Mario Draghi has already made his plea. During the Fed’s Jackson Hole event, he admitted the ECB were ready to do more but called on the fiscal agents to do their part. The speech was a huge shift in rhetoric from Draghi and heaped more pressure on the Germans to change tack. The Germans have been very dismissive of the speech. I haven’t seen anything positive on it in the German press. That tells you they aren’t willing to move aggressively.  Moreover, my sense is that Draghi was talking more out of desperation than anything else. He was basically saying there is only so much the ECB can do. We will do everything we can within our restricted mandate..and then some. So don’t blame us when crisis returns.

With the Germans dragged down the stimulus path kicking and screaming, all we can hope for is some EIB-type measures and a few other table scraps. Fiscal is not in the cards because the Germans, at over 80% government debt to GDP, don’t think they have the capacity for fiscal. The Germans lobbed in their first outright debt reduction this year since the 1950s. That speaks volumes about the German mindset here.

So, Europe is in a holding pattern here. We will see movement at the margin, both from the monetary agent, the ECB, and from fiscal target relaxation and European-wide infrastructure-style stimulus via the European Investment Bank. But I do not sense any urgency to move aggressively. Nor do I think the Germans want to fundamentally alter their approach to the crisis. Europe is stuck in a slow growth paradigm until something breaks and forces a reaction.

In the meantime, the ECB policy will become more accommodative just as the Fed is becoming less accommodative. This sets us up for serious portfolio preference shifts and large cross-border currency flows as investors adjust to the widely divergent monetary policy stances. I think the liquidity associated with these flows could help promote asset-price inflation and leverage as investors use the carry trade to boost returns. So overall, this move is bullish for asset markets, whether they are in the US and UK, where the central bank is tightening, or in Europe where the ECB is loosening. The result of these flows, however, could be volatility because the real economy is still weak and global growth is weakening. I will have more thoughts as the situation develops.