The longer the financial markets thought about the actions announced by the European Central Bank today, the less impressed markets were. The STOXX 600 Europe Index had climbed as much as 2.5% during the day, but after peaking around 1 p.m., the index finished down 1.7% for the day. The French CAC 40 ended lower by 1.7% and the German DAX was off by 2.3% at the close.
The problem was that European Central Bank President Mario Draghi undercut, as far as the market was concerned, more forceful than expected action with his comments to reporters. The bank announced another 10 basis point cut to its overnight deposit rate to a negative 0.4% (as expected); raised the amount of assets it aims to buy each month to 80 billion euros from 60 billion (10 billion more than expected) and that it would add corporate debt to its potential purchases.
Nothing startling there but more than expected.
But Draghi then said that the central bank is done–at least for a while. “From today’s perspective, we don’t anticipate it will be necessary to reduce rates further,” he said. The package “is an adequate reaction to a weakening of the growth and price-stability prospects,” Draghi added. “We think the measures we took today are adequate to address the change in economic conditions that occurred since our last monetary policy meeting.”
Which seems puzzling since he also noted that inflation is expected to remain negative (deflation in other words but without saying the “d word) in the coming months but will pick up later in 2016. (Inflation in February was a negative 0.2%.) The central bank lowered its inflation forecast for 2016 to 0.1% from the 1% forecast in December. Inflation will climb to 1.3% in 2017 and then 1.6% in 2018.
Last time I checked the math 1.6% is still less than the 2% target the bank has set as a goal for its program of asset purchases. And the bank is now projecting that inflation will remain below that target through 2018.
The European Central Bank also cut it forecast for economic growth in the EuroZone to 1.4% in 2016. That’s below the 1.7% growth in GDP the central bank forecast in December. The EuroZone economy will grow by 1.7% in 2017.
So let’s see–inflation lower than the target and economic growth tepid into 2017. Yep, I can see why the European Central Bank announced that it was done for a while.
On the news the euro climbed to $1.1207 against the dollar–after falling by as much as 1.6% earlier.
The most important take-away to me from today’s announcement and the market reaction is that traders and investors are becoming increasingly skeptical about the ability of central banks to stimulate higher growth and to generate higher inflation.
The bag of tricks announced today by the European Central Bank didn’t contain anything new and the same old, same old–even more of the same old, same old–doesn’t have the old magic that it once did.
Just about every reason I had to buy the iShares Currency Hedged MSCI Germany ETF (HEWG) back on March 12, 2015 has evaporated.
Weaker euro against the U.S. dollar to drive Germany exports higher? Nah.
Recovery in global growth to add to export earnings for German companies? Nah.
European Central Bank stimulus policies to add to economic grown in the EuroZone? Nah.
What do you do when all the reasons you have to buying and holding a position disappear? I don’t think there’s any thing else to do but sell. And that’s what I’ll be doing for my position in the iShares Currency Hedged Germany ETF tomorrow. I’m selling this position out of my Jubak Picks portfolio with a loss of 27.39% as of the close today, February 11.
This sell doesn’t mean the Germany economy won’t see better growth at some point in the future, or that China won’t see higher growth down the road and push the global economy toward faster growth, or that the Federal Reserve won’t raise interest rates in 2016 and lead the dollar back up against the euro.
It’s just that I see those trends taking a good while to get unlimbered. And when this current consolidation stage in the market does resolve itself into new market leadership, I think other stocks will show a faster rebound off the bottom than this ETF will. I am concerned at the persistent weakness in the European banking system and the length of time that it’s taking for that system to wash out its bad debts, but this sell is mostly not a sell because I believe that there’s still a tremendous drop ahead of German equities (German equities are already in the bear market) but because I believe that once the trend in the market does turn, there will be better opportunities elsewhere.
At the moment, I don’t know where those opportunities will be but I’m raising some more cash here so that I have the money to pursue them when that’s appropriate.
On my paid site CURRENCIES week has ended with a post “3 strong dollar, weak euro (and Brazilian real) picks”
For the last week or more on my paid site JubakAM.com I’ve been writing about currencies.
How long will the dollar rally go on?
What’s the bottom for the euro and what route will it take to get there?
Is the biggest looming danger in global markets right now a potential devaluation of China’s currency?
Today, I ended this string on currencies with a post giving three picks for a strong dollar/weak euro market. You’ll recognize one of the three–it’s the iShares Hedged Currency MSCI Germany ETF (HEWG) that’s in my Jubak’s Picks portfolio. The other two are Luxottica (LUX), a member of my long-term 50 stocks portfolio and (surprise) BRF (BFRS), a Brazilian producer of chicken and beef and packaged foods. The post offers some timing advice on when to purchase and, of course, much more detail on why these picks make sense to me now.
For that, though, you’ll have to subscribe to my JubakAM.com site. Tomorrow on that site I’n going to take a brief trip through the banking sector–remember bank stocks are supposed to do well when interest rates are going up, and then I’ll start a string on oil (with an explanation of what the Saudis were thinking when they led OPEC to do away with production quotas.)
That’s what I’m working on at my subscription JubakAM.com site. I think there’s some value to you in passing on the direction of my thinking about the market on that site. Hope so anyway.
Of course, there’s an ulterior motive to sharing this with you: If you decide that you’d like more detail on my JubakAM.com posts, I’m hoping that you’ll subscribe to my site at JubakAM.com for $199 a year. (By the way, you can get a full refund during the first seven days if you change your mind for any reason.)
On Thursday December 3 the European Central Bank will send deposit rates even further into negative territory, increase the amount of bonds that it buys each month, extend its program of asset purchases, and expand the range of assets that it buys—or maybe all of the above.
The financial markets will be waiting to see if central bank President Mario Draghi throws the kitchen sink at the EuroZone’s combined problems of slow growth and even slower inflation or if he keeps some policy options in reserve.
You should watch to see how the currency markets—especially that for the dollar and the euro—behave. Will we see the euro rally and the dollar drop on a sell on the news reaction? Or will the dollar keep climbing against the euro on a belief that a strong dollar is about to get even stronger after the U.S. Federal Reserve raises interest rates?
The euro fell another 0.3% against the dollar today to close at $1.0565. The EuroZone currency fell 4% in November and finished the month down 12.65% for the year.
To me it looks like the market has priced in much of the kitchen sink program and if that’s the case I think it’s likely that we’ll see a bounce in the euro here. There’s strong support for the euro near $1.04, a level that marks the March low for the euro. If Draghi gives traders much of what they expect on December 3, I’d expect to see the euro move up slightly on the theory that all the likely news is priced into the currency pair and that the move to $1.04 isn’t enough to stick around for.
That makes sense to me in the short term, but in the medium to longer term a euro bounce assumes that Draghi’s new dose of the same medicine that hasn’t worked very well to increase inflation and or growth will work this time. That seems questionable to me at best—why should more of the same work now when it hasn’t done much of anything over the last six months?
I’d expect to see a renewed downward trend in the euro not too long after any bounce as the dollar resumes its climb after the Federal Reserve finally raises interest rates in December (current odds better than 70%) or in early 2016.
If you’re looking to put on weak euro/strong dollar trade, I’d wait to see if we get a bounce on the news after Thursday and then look for a resumption of the euro’s decline and the dollar’s rise.
Back on March 12, 2015, I added iShares Currency Hedged MSCI Germany ETF (HWG) to my Jubak’s Picks portfolio at a purchase price of $28.11–or at least I thought I did. For reasons that I can’t identify, the buy never made it into the portfolio–although it did get posted on my subscription site JubakAM.com. Today I fixing the omission and entering a buy with my original March 12 price.
Here’s the March 12 post that went with this purchase.
Hedged or unhedged
I’ve spent the week since I wrote http://jubakam.com/2015/03/everything-and-i-mean-everything-you-need-to-know-how-to-invest-in-the-eurozone-now/ on my subscription JubakAM.com site about why putting some money into an ETF focused on a European export-oriented economy such as Germany or Poland was a good way to play the asset purchase program that the European Central Bank announced in detail on Monday, March 9.
I had been inclined to say, “unhedged.” I can easily remember when everything thought the drop in the euro would end at $1.25 or $1.20 or most recently at $1.10 or at parity with the dollar ($1.00.)
The euro closed at $1.0551 today, March 11. If the bottom was $1.00 that was only a further 5.2% drop from here—not a terrible risk—and if the euro were about to rally, then I’d sure like to participate in the bounce.
Now, however, big money managers are talking about this decline in the euro going on into 2017. For example, Deutsche Bank, which was bearish at the euro at the beginning of the year, has gotten even more bearish. The bank is now talking about parity for the euro to the dollar by the end of 2015 and then a continued decline to 85 cents to the euro by 2017.
Yipes. That’s a 19% drop in the euro. Enough of a potential currency loss to wipe out much of any potential gain in share prices.
As of tomorrow March 12 I’m adding iShares Currency Hedged MSCI Germany ETF (HEWG) to my Jubak’s Picks portfolio http://jubakam.com/portfolios/ . (I’m picking this ETF above competitors Wisdom Tree Germany Hedged Equity ETF (DXGE) or Deutsche X-trackers MSCI Germany Hedge Equity ETF (DBGR) because it is about 10 times larger and in this market I’m more comfortable with more liquidity rather than less.) The iShares Hedged Currency MSCI Germany ETF closed at $28.32 on March 11. The expense ratio (with fee waiver) is 0.53% and the ETF yields 1.76%. I calculate a target price of $34 a share by the end of 2015
So why have some big investment houses become so much more negative on the euro lately—and why do I believe them?
It’s a reflection of a deeper study of how the European Central Bank’s program of asset purchases is likely to affect interest rates in the EuroZone. The conclusion is that the plan will send already low rates even lower.
I know that sounds impossible. After all the 2-year German note already yields a negative 0.25% and the 5-year note yields a negative 0.13%.
But it’s not impossible that yields will go lower. It’s actually probable given the structure of the bond market in the EuroZone.
Here’s the problem: Thanks to the EuroZone’s focus on austerity member countries haven’t been issuing much new debt. And they don’t have plans to issue much new debt.
Net issuance of new debt in the EuroZone between now and September 2016—the projected life span of the European Central Bank’s asset purchase program—is projected at just 413 billion euros, according to JPMorgan Chase. I say “just” because the European Central Bank wants to buy 850 billion euros of debt securities. That leaves new supply short of central bank demand by a huge 437 billion euros.
That’s how much the central bank will need to buy in already issued bonds from current owners. To pry them out of the hands of current owners, the European Central Bank will have to offer to pay higher prices—and higher prices translate into lower yields. (Especially since many banks hold these kinds of assets as core parts of a capital bases required by regulators.
The problem will be most acute in the market for German bonds where the bank will be looking to buy 200 billion euros of German government debt and the supply of newly issued debt will be just 6 billion euros during this period.
Getting current bondholders to sell isn’t going to be easy in the case of large institutional holders such as insurance companies and pension funds. These institutions own these bonds because they match projected liabilities in both payout and maturity. Exactly what are these companies supposed to buy to achieve those goals if they do sell their current holdings?
Part of the more negative assessment of the effect of this program of asset purchases on yields and the euro reflects calculations of how quickly asset purchases will reduce the supply of bonds suitable for purchase. The European Central Bank’s plan says that it won’t buy any bond with a negative yield of more than 0.2%. That’s the price that the central bank now charges individual banks to keep deposits in central bank vaults. The negative 0.2% figure is an effort to limit the losses the central bank would take if it buys a bond with a negative yield and yields then wind up climbing. (As they would at some point if this program of asset purchases does indeed increase growth and inflation rates.)
But look how that limit works to reduce supply. Once upon a time—like Tuesday, March 10—the central bank could buy German notes maturing in April 2018, a little more than three years from now. But yields on those notes fell as the price of those notes climbed so that on Tuesday yields fell to a negative 0.23% and these notes were no longer allowable purchases by the central bank.
In effect purchases—or anticipated purchases–by the European Central Bank acted to reduce the supply of bonds available for purchase and to increase the upward pressure on the prices of remaining bonds in the market—with the result that yields on those bonds fell too.
Much of the early worry about this process has focused on the question of whether or not the supply of bonds available for purchase would be exhausted before the program of asset purchases reached an end.
The more recent focus, however, has been on the effect of the asset purchase program on yields now. And the result of this analysis has been to suggest that European bond yields will be in the midst of any even deeper drop just as the U.S. Federal Reserve begins to raise interest rates in June or September.
And that will mean, this analysis says, an even weaker euro than projected earlier.
Of course, there is always the additional possibility that the European Central Bank’s plan won’t work—in which case the central bank will arrive in September 2016 having spent 1 trillion euros on asset purchases with nothing to show for it except deeper negative interest rates on a larger portion of the existing European bond supply.
You can bet the euro would love that.