MorningWord 06/05/14: Passing the Baton – $FXE

by Enis June 5, 2014 9:21 am • Commentary

“Who controls the food supply controls the people; who controls the energy can control whole continents; who controls money can control the world.” -Henry Kissinger

The central banks control the money.  Especially the FOMC and the ECB, which control the two major reserve currencies of the globe.  The ECB reduced the deposit rate to negative 0.10 percent this morning in a historic move, and announced in its press release (here) that further measures would be announced later this morning. Mario Draghi is currently speaking, and has indicated that the additional measures would be targeted LTRO’s (long-term refinancing operations) and work to prepare for eventual Quantitative Easing.

Mario Draghi and co. have stated their main concern as low inflation.  What’s interesting is to me is that inflation has been below 1% on several occasions over the past 20 years, but this is the first time the ECB is has cut the deposit rate below 0:

EU Core CPI Year-over-Year, Courtesy of Bloomberg
EU Core CPI Year-over-Year, Courtesy of Bloomberg

I see 2 real reasons (separate from the low inflation, which has not spurred such action in the past) for more aggressive action from the ECB today:

1.  The ECB is subbing in for the Fed on QE – the central banks talk to each other quite closely.  They have made it clear that they are concerned about the potential negative market effects of the end of QE from the Federal Reserve.  The Fed does not have much cover to maintain QE with inflation now rising and unemployment already below 6.5%.  However, if the ECB takes up the QE baton from the Fed (or gets more aggressive with QE-like asset purchase measures), then the end of asset purchases by the U.S. central bank might have a negligible impact on global asset markets.

2.  The ECB wants the Euro lower – The ECB only started talking more aggressively over the past 6 months, even though growth has been stagnant for several years.  It just so happens that the Euro reached multiyear highs vs. the U.S. dollar in that period as well:

EUR/USD cross rate weekly chart, Courtesy of Bloomberg
EUR/USD cross rate weekly chart, Courtesy of Bloomberg

Draghi’s main impediment to implementing more aggressive monetary policy measures over the past few years has been German opposition.  The rise in the EUR/USD was not welcomed by many in the German business community, who are quite reliant on exports.  As a result, the strength of the EUR finally gave Draghi the support he needed from the German contingent to get more aggressive.

Amidst today’s excitement, it’s worth noting that the ECB has already influenced long-term rates a significant amount over the past 3 years.  Italian and Spanish 10 year yields are now below 3%, only 20-30 bps away from U.S. 10 year yields, and Portuguese 10 year yields are at 3.6%.  That fact alone is incredible (and quite insane in my view).  Would you want to lock away a 10 year bond for those returns with the sovereign counterparty risks?

What’s it all mean for U.S. stocks?  If the ECB follows through with today’s indications, then it might soften the blow of the Fed’s gradual withdrawal from asset purchases.  At the least, it’s one more signal to traders that the central banks, who control the money, are prepared to act very quickly at the first sign of volatility.