Pro Perspectives 10/24/19

October 24, 2019

The ECB met this morning and made no adjustment to the plans to restart QE.  Why does the ECB matter?

Remember, by the ECB ending it's three-year QE program last December, a stabilizer of global liquidity was removed – an offset to the Fed's QT was removed.  With that, a shrinking global balance sheet of the top three central banks in the world proved disruptive for global markets and the global economy.  We now have the ECB back in the QE business.  And the Fed has not only stopped QT, but is now expanding its balance sheet again.  

This was Mario Draghi's last meeting and press conference as head of the ECB.   This is the man that led the strategy to avert disaster for Europe and the global economy back in 2012. A contagion of global sovereign debt defaults were lining up in Europe.  And the second most widely held currency in the world, the euro, was vulnerable to a break-up.  To stop the meltdown, Draghi publicly threatened/vowed to become the backstop in the European government bond market.   

Here's what he said in a July 2012 speech: "the ECB is ready to do whatever it takes to preserve the euro.  And believe me, it will be enough."

The imminent risk was sharply rising yields in the big, dangerous weak spots in Europe:  Spain and Italy.  Speculators were hitting the bond market, yields were rising to unsustainable levels.  Spain and Italy were on the path of default and once one went, the others would fall.  The next step would mean these countries leaving the euro, returning to national currencies and inflating away the debt through currency devaluations. 

It didn't happen because Draghi stepped in.  With the statement above, he threatened to be the unlimited buyer of these troubled government bonds, which was enough to purge the speculators from the market.  Quickly the yields on those bonds plunged, without Draghi having to buy a single bond. 

Here's what the chart of those bond yields looks like …

Trouble in Europe means trouble for the global economy.  So, when the rules aren't working, don't underestimate the appetite of policymakers to change the rules.  That's what Draghi did.  He backstopped the bond crisis, and later launched QE.  The global economic recovery was back on path.

Now, in this post-financial crisis world, as long as everyone's fate is interconnected, there are few, if any, market penalties for what may seem to be desperate, dangerous and profligate actions.

With that, we've talked about the prospects of the ECB turning to the stock markets — to become buyers of stocks, to help boost wealth, confidence, hiring, spending and investment.  When Draghi was asked today about the options the ECB has to enlarge the composition of the asset purchase program, he ignored the question and went into a long-winded answer about something else.   That's the elephant in the room.  The WSJ ran a piece today saying the ECB would run out of bonds to buy by the end of next year — proposing equities as an option.