The major event that will have an impact on stocks for at least the first half of this year is the upcoming ECB meeting on January 22nd. It is widely expected that the outcome of the meeting will be a significant policy change so that policymakers can stave off the deflationary spiral that is threatening the Euro zone. But deflation is already there:
This is hardly the "shock and awe" that accompanied both the US and Japanese QE efforts. And there in lies the concerns market participants are starting to have and has been, in my opinion, an attendant reason for the market volatility the past few weeks.
First of all, there's a possible chance that there will be no announcement on Thursday, the 22nd. ECB President Mario Draghi made that clear in his last press conference. The announcement could come in June. But the chart above speaks for itself and, like inflation, waiting will only exacerbate the deflationary spiral. Many are arguing that it may already be too late to stem the tide.
Secondly, there is the important argument surrounding how effective sovereign bond purchases would be. Yields are already so low that the benefits in attempting to push them lower may not be worth it and may create other significant distortions that make the effort dangerous. After all, if the ECB buys the debt, who holds it? This is an ongoing debate in the ECB governing council and rumors persist that while the ECB will implement the policy the national banks will hold the debt. But in a deflationary environment national banks take on a dangerous exposure if the bond buying does not accomplish the goal of reflation. And then there's always the moral risk associated with these purchases which is behind the Germans main objection to this proposal.
Behind the German concerns and a huge part of the problem is the quiet recognition in the Euro area that monetary policy can only go so far in "kick starting" a recessionary economy and that fiscal policy must take over. But there is no will in the Euro zone, either among the Italians, French or the Germans to confront this issue. I cite in defense of this position the recent submission of France's national budget to the EU which was over the mandatory 3% deficit threshold. The result is that they went into "negotiations" with the EU on this budget and the whole issue was essentially glossed over.
I understand that issues are much more complex than stated above but these events underline the deeply flawed concept behind the EMU (European Monetary Union). Monetary union without fiscal/political union is untenable.
And so the Germans, which are the deep pockets over there, don't want to get caught holding the bag. And they have significant political sway in the ECB although they can be overruled.
So, whatever is announced on Thursday (if it is announced) is more likely to disappoint the market than to encourage it. Certainly a "shock and awe" surprise would be met with frenzied buying in the equity markets but no rational person can expect this outcome.
It's difficult to speculate the market reaction, especially with the focus on the price of oil (another deflationary beacon notwithstanding arguments that it's about oversupply). But I now believe the best outcome will be for the market to take the announcement in stride unless they postpone their decision.
If they postpone the decision things will probably get ugly. If they come in with $500 billion in sovereign purchases we're liable to see a rally but not of the magnitude I previously had predicted. After all, as stated above, they're at the point where they are confronting diminishing returns unless they go "all out"; buying anything and everything they can in the bond and debt markets. And for reasons stated above, they will not do that.
However, the market is wiser than any individual or entity engaged in it and anything can happen. The fact that inter market relationships are getting tricky and that emerging markets have been resilient in the face of significant volatility is encouraging to me.
There are also issues going on in Greece that I'm not too concerned with at this time but which must be watched. And it is becoming more apparent that the Fed's anticipated interest rate increases will be postponed until later in the year? Remember "Liquidity Traps Revisited"? I'll be addressing these issues in my next commentary in two weeks.
Have a great week!
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