Mario Draghi, president of the European Central Bank, has not been in favor of moving into a program of quantitative easing, basically, because he does believe that a program of quantitative easing does what Europe wants…to stimulate more rapid economic growth.
After seeing the United States go through three rounds of quantitative easing, Mr. Draghi seems unconvinced that this sort of a program can do much to stimulate more rapid economic growth.
To see a list of high yielding CDs go here.
Hence, he wants to try a program in which the ECB will buy asset-backed securities and covered bonds. The rationale behind this is that these securities are closer to bank lending and by buying these securities, the banks will be more likely to enter the market and make more business loans.
Asset-backed securities are composed of bundled loans that have been sliced and diced and placed in specially created instruments that are not required to rest of the balance sheet of the originating bank.
Covered bonds are also debt securities that are backed by the same kind of loans but are kept on the balance sheet of the originating bank.
Since both of these securities are backed by bank loans the feeling is that when the ECB buys the bonds, and removes them from bank accounting, the banks will then want to take the money they receive and go right back out into the market and make some new loans. This will get the loan market moving…in Europe, the banks have just not been lending…and, hopefully, get economic growth going again.
Since both asset-backed securities and covered bonds are both related to actual bank loans, Mr. Draghi believes that this will get funds back into circulation again whereas if the ECB buys government securities…which would be the case with a quantitative easing program…the monies would not get as easily back into the bank lending stream.
The reason for having any kind of securities purchase program at all is the fact that the eurozone, including Germany, is on the brink of a recession and faces the possibility of actual price deflation, which would not only make it harder for borrowers to pay back their loans, but would also have the cumulative effect of making business just that much worse.
It is expected that the European Central Bank will buy up to 1.0 trillion Euros of these bonds.
One direct effect of this ECB moving to this aggressive security-purchasing program has been for the Euro to decline in value. A cheaper Euro, hopefully, will result in the eurozone being able to sell more goods to countries outside of the eurozone and this will help to pick up economic activity.
Earlier this year the value of the Euro was in the $1.39 to $1.40 range. As Mr. Draghi and the ECB eased policy interest rates and prepared the securities-purchasing program, the Euro dropped first to $1.35…then $1.30…and after the October board meeting, the value of the Euro closed as low as $1.2513 on October 10.
It has backed up a little bit since then, but was trading around $1.27 on Tuesday, October 21.
Some analysts believe that with the ECB buying 1.0 trillion Euros worth of securities that the value of the Euro will drop to at least $1.20…or even below.
During this time, the concern over the slowing rate of economic growth in the eurozone and the possibility that the disinflation within the community will actually turn to deflation, longer-term interest rates have declined.
The yield on the 10-year German bund dropped to close at 0.76 percent on October 15, an historic low. Investors are feeling that Europe’s growth rate along with its inflation rate are not going to recover any time soon and so that are transmitting this feeling into their investment decisions.
The concern about the slow growth rate and disinflation in the eurozone has crossed the Atlantic Ocean and has impacted United States interest rates. The fear is that the slow growth and deflationary environment in Europe might be transferred to the United States. The yield on the 10-year US Treasury note dropped in parallel with the yields on German bunds.
On October 15 when the yield on the 10-year German bund hit its historic low, the yield on the 10-year Treasury issue dropped to a near-term low of 2.15 percent.
This is a situation that investors in US bonds need to follow closely.
Things are not going to change rapidly in Europe. It takes time for monetary policy to work and turn around economies, and it takes time for the environment to return to a more “normal” situation. So, what goes on in Europe and what goes on at the European Central Bank will take some time.
And, there may be other policy changes. Many analysts don’t believe that the current program of purchasing asset-backed securities and covered bonds will do the job. They believe that the current actions of the ECB are just the beginning and that the central bank will…sooner or later…have to actually begin a policy of quantitative easing.
So, there is still much to watch and anticipate from Europe and European policymakers.
But, things are not over here in the United States. If the slow growth…and possibly deflation…from Europe impacts the United States, then Federal Reserve monetary policy might be changed.
Already, some policymakers are suggesting that the time to begin raising short-term interest rates needs to be pushed off further into the future because the economy is likely to stay weak longer than had previously been expected.
Others have even talked about the possible need for a fourth round of the Federal Reserve’s quantitative easing.
So, investors need to keep their eyes and ears open…and be aware of what is going on elsewhere in the world…and not just what is going on in the United States.
The interesting times do not yet seem to be over!
About John Mason John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.