Macro: The Bottom Line (9/8/2014)

The ECB and the euro: make way for the Big Bertha 

 

The euro has gone full circle within 12 months. After rising to nearly 1.40 versus the USD from last summer through May, the currency has since gone practically only one direction: south. Last week, it crossed a psychological barrier, dropping below the 1.30 handle for the first time in 2014.

The reasons for the summer slide should be no surprise to Red Bull readers. Early this year, we argued that, with the Euro region experiencing a rocky recovery and facing deflationary threats, the ECB would have no choice but to pull out the Big Bertha - i.e. flood the system with liquidity. For a while, ECB President tried to tiptoe around pulling out the big guns: starting with some jawboning in the spring, he then cut deposit rates to negative in June (along with unveiling some conditional liquidity measures). But even that didn't solve the issue - instead, inflation continued to trend lower (YoY Eurozone inflation now stands at a mere 0.3 pct), and GDP growth remained stagnant (with Germany contracting in the 2nd quarter).

So last week, Draghi finally did the inevitable and rolled out the Big Bertha. He announced that the central bank would start purchasing securitized assets outright in October. Remember, these are the dicey securities - backed by consumer loans, auto loans, mortgages etc. - that wreaked so much havoc on the financial system back in 2007-2008. The thought is, by underwriting the risks of such securities via the ECB's balance sheet, commercial banks in Europe would have fewer qualms about extending credit. This, in turn, would help jump-start the moribund economy. Or at least so the theory goes.

There are certain unknowns though about going this route. Key details - such as the size of the program - remain unclear. Reuters reported that the purchases could total at least 500 billion euros. But there's an important impediment to reaching this size: lack of liquidity of the European securitized market. You see, the total stock of securitized assets outstanding as of 1st quarter 2014 is little more than 1 trillion euros (according to HSBC calculations). In contrast, the U.S. Federal Reserve focused its quantitative easing on the Agency MBS market (whose outstanding stock was over $7 trillion in 1st quarter 2014). So the ECB will have to weigh - to a much greater extent than the Fed - whether the potential market dislocations from its actions represent a risk worth taking. After all, the more realistic option for the ECB to achieve the necessary scale would be to purchase government bonds. But it has already faced stiff German opposition to doing so, and will likely continue to do so.

For these reasons, the Big Bertha's effects on the Eurozone's real economy are unlikely to be immediate. However, the impact will be felt in risky financial assets - be it higher-yielding government bonds, emerging-market assets, or equities. These assets already reacted positively to the news, and will likely remain well-supported for some time. At least until the Fed diverges from the ECB and starts hiking rates (likely in the second half of 2015).