All eyes on the ECB

SFG Alternatives CIO Larry Shover on what to expect from the European Central Bank.

This article is part of the series

Laying Bare Our Complacency – Trading with a Central Bank

By From the Trading Pits FOXBusiness

On Thursday,  European Central Bank (ECB) President Mario Draghi is widely expected to follow the well-trodden pathway of America, Britain, and Japan by announcing the Eurozone will embark on a program of asset purchases.  Expect a declaration of either “so and so will buy such and such” or “we have nothing new to share.”  Most likely, it will be the former for long gone are the days when lords would allow its serfs to experience economic longsuffering – kings and kingdoms of the 21st century want immediate results – waiting for a crash and self-correction is reserved for economic fables and dusty textbooks composed in Vienna.

Continue Reading Below

The scenarios are deeply intricate and the stakes have rarely been higher. If the January 15 Swiss National Bank (SNB) action to retune its currency didn’t send a grim reminder of what could happen – nothing will. 

From former Federal Reserve Chairman Ben Bernanke’s maiden QE voyage to last summer’s central banker’s divergence point, markets were marked with general listlessness producing a new-fangled generation of deeply complacent investors. This obtuseness sharply resembles the 1977 USCG report on the 1975 sinking of the Edmund Fitzgerald.  “The nature of Great Lakes shipping, with short voyages, much of the time in very protected waters, frequently with the same routine from trip to trip, leads to complacency and an overly optimistic attitude concerning the extreme weather conditions that can and do exist.”  It’s quite premature to throw rocks at QE – it certainly accomplished its mission of forcing investors along the ledge of financial repression and, in the process, fed tinder wood to companies while the risk-takers made bundles.

Presently its prerogative that Draghi will somehow and someway expand the ECB balance sheet – all with high hopes of gobbling the supply of debt, sharing the risk “fairly and squarely” per the continent, with promise of fast-forwarding a stagnant European economy.   The type is currently cast for a 750 billion euro package – 500 billion in Sovereign purchases while the balance would contain a smattering of both covered and corporate bonds.  Tuesday, it appears markets have received the tomorrow’s paper today as the euro FX forward curve is trading with implied negative rates out to 14 months.  Consensus expects QE and money-changers are emphatically pricing in lower rates faster than we can count.

However, truth and governing will ultimately be in the details and how this news will be absorbed by the markets greatly depends with both its schedule and size.  The simplest solution is for the national central banks (NCB) to purchase their own bonds and assume their own credit risk; the less credit risk is shared, the larger a purchase program could become.  However, simple is not always the least path of resistance as the legal, political, and social obstacles are excruciatingly difficult and, any news on this will be critical to the markets in the near-term.  At this point, both Draghi and consensus know it will be far easier to surprise on size than schedule – markets aren’t compassionate yet will afford Draghi a longer rope as long as the message is stable.

 

Continue Reading Below

Sharing is Caring

Thursday, the rubber hits the road – where “sharing is caring” - where the very best outcome would be for Draghi to proclaim a large degree of risk-sharing among member central banks – anything at or above 50% (sharing) would propel risk assets to the stratosphere.  Anything beneath 50% would be regarded blasé causing stocks and bonds to revert back to their recent, most volatile ways. 

A complex hybrid announcement will likely cause a sudden knee-jerk reaction however, once the dust settles, investors may want to buy medium-to-large cap European equites as you will have the double benefit of QE and a weaker currency which should benefit the international names compared to their domestic small-cap brethren.  Buy French and Italian equities over Germany or the U.K.  Buy cyclical over defensive.

Make no mistake about it, the risks in Europe are many and, in some cases worse than ever.  However, we must realize the inputs into this frame are vastly different than the U.S. in that Europe is in the midst of reconfiguring its capital market system – its arduous and unrewarding work but work that is being done directly beneath the noses of the rest of us.

What do you think?

Click the button below to comment on this article.