Will ECB Do QE in 2014?
Interest rates and deflationary pressure are pushing Draghi to make a change in policy.
Regarding negative interest rates, that certainly could force money out of banks and into the economy as idle cash gets, well, "tapered," but there are many butterfly effects and unforeseen consequences that can be damaging under such a move. Regarding quantitative easing, the jury is still as to whether or not buying bonds is actually effective as forcing reflation in the economy as opposed to just asset markets. However, QE likely has much less stigma attached to it than negative interest rates.
To some extent, the actions of the Bank of Japan and Federal Reserve have provided a framework and cover for the European Central Bank to enact quantitative easing, even if evidence does not support its ability to reflate underlying economic growth. One would assume that Germany would be averse to this. However, the higher the euro goes, the more amenable Germany's policymakers may be to QE under the idea that it could cause depreciation in the currency and spark export growth, similar to what's happened in Japan. Indeed the hardest thing to do for any central bank is to do nothing, but Draghi's "whatever it takes" pledge is at risk.
The clock is ticking on deflation becoming entrenched, and risk sentiment is waning into new highs. Take a look below at the price ratio of the iShares Spain ETF (NYSEARCA:EWP) relative to the iShares Germany ETF (NYSEARCA:EWG). As a reminder, a rising price ratio means the numerator/EWP is outperforming (up more/down less) the denominator/EWG. A falling ratio means the opposite.
Consider this a gauge on underlying risk sentiment. Spain is considered riskier and more sensitive to reflation than the bigger "safer" Germany. Note Spain has been underperforming as deflation concerns have been getting more attention. Continued weakness here means money -- which has caused a meaningful move in Europe over the past five months -- may waver on what's happened recently in terms of it simply being a trade versus a long-term investment.
If European asset markets begin to falter, the ECB may have no choice but to prop up assets with more stimulus to counter overwhelming deflationary pressures. However, these tools may ultimately not work in terms of their intended consequence for the underlying economy. All that means is that from the standpoint of anticipating the anticipation of others, more money is coming, causing continued divergence of asset markets to underlying fundamentals.
Analysis required? No – not when central banks keep trying to fight short sellers with the printing press.
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