Hang on a Minute…Quantitative Easing Does What?

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Before getting stuck in to today’s Daily Reckoning, I want to give you a heads up on something I’ve been working on. It’s a story about what I think could well be the single best investment play of 2015. I told my subscribers about it at the end of last year, and this investment idea is already off to a very strong start.

But this year and beyond, I think it has a lot more upside potential. If you’re a regular reader of the Daily Reckoning, you’ll know that I don’t do this sort of thing very often. But in this case, the story is very compelling.

So check your inbox this afternoon. I hope you like it.

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Back to the news…

It was the central banking show again overnight with markets positioning ahead of the European Central Bank’s (ECB) meeting on interest rates, which takes place tonight. It’s widely expected that the ECB will announce their own version of Quantitative Easing (QE).

Although the actual announcement is set to be a bit of a fizzer.

Why?

Because the news is already out. The ECB leaked the plan overnight, suggesting that it will buy €50 billion of bonds per month for up to two years. That’s a potential debt monetisation program of €1.2 trillion.

As usual, the mainstream media is peddling the central bankers’ line in promoting the news. That is, the QE program will help offset deflation and revive the economy. The afr.com reports (via Bloomberg) that:

Mario Draghi called on the European Central Bank to make its biggest push yet to fend off deflation and revive the economy by unleashing a debt-buying spree of €1.1 trillion.

Here’s the Financial Times’ take:

Ahead of the conclusion of a two-day policy meeting on Thursday, a number of media reports claimed the ECB was considering buying around €50bn-worth of government bonds a month for between one and two years, as part of its plans to bolster growth and fight deflation in the eurozone.

Until now, market speculation had centred on a €500bn programme. But the latest reports implied the ECB would buy at least €600bn-worth, and possibly as much as double that if it continued buying for two years.

Hang on a minute…just hang on.

Let’s think about this.

QE is a process where the central bank buys the bonds of various sovereign governments. The aim is to push interest rates down to encourage lending. This lending boost, apparently, will stimulate demand and lead to renewed economic growth and inflation.

That’s the bedtime story version. It’s a fairy tale. It might make for happy reading, but like the little girl Goldilocks wondering through the woods by herself and ransacking a bear’s house before fleeing when discovered, it actually makes no sense when you really think about it.

Let me explain…

European government bonds yields are the lowest in history. Below is a table from Bloomberg showing the ten year bond yield (or borrowing rate) for a range of European countries, and the yearly change in bond yields, expressed in basis points.

So Germany, for example, now pays just 0.52% to borrow for 10 years, which is 121 basis points lower than 12 months ago. Put another way, this time last year, Germany’s borrowing cost was 1.73%.

If you want to lend to the Swiss, it will cost you 0.26% per year for the next 10 years. I know it’s crazy, but it’s true.

Every European country on the list below, except Greece, has experienced a sharp drop in borrowing costs over the past year. Clearly, the bond market thinks there is a high risk that Greece will exit the Eurozone at some point soon, hence its bond yield’s heading in a different direction.

Country

Yield

Yearly Change

Germany

0.52%

-121

Britain

1.50%

-133

France

0.70%

-170

Italy

1.69%

-214

Spain

1.52%

-220

Netherlands

0.56%

-149

Portugal

2.75%

-229

Greece

9.07%

+135

Switzerland

-0.26%

-132

 

The point to note here is that despite record low interest rates, the European economy continues to remain weak. Record low borrowing costs haven’t helped at all.

What is a round of QE going to achieve? I mean, really?

All it does is allows banks to sell their most risky (or unwanted) government bonds to the central bank, and use the money they get in return to speculate on other assets.

So don’t believe any of this nonsense about QE preventing deflation and reviving the economy. QE is a smokescreen to fund governments and help the banks make trading profits.

The Germans, led by Bundesbank President Jens Wiedmann, are right about QE. They say it’s not necessary and reduces the incentives for governments to make structural reforms.

And that’s the problem with Europe. It has many structural impediments to growth. The cost of money and credit is not one of those impediments.

In contrast, the US has a flexible economy relative to the Eurozone. That’s why the economic recovery there has been better than in Europe. It had nothing to do with QE. Arguably, the first round of QE back in 2009 was useful in taking pressure off banks’ balance sheets, but the rest just went into asset price speculation.

Anyway, it’s uselessness in reviving the economy is not going to stop them giving it a crack. So expect tomorrow to be another day of central bank dominated news.

But just watch out for the old ‘buy the rumour, sell the fact’ trade. That is, markets around the world have rallied this week based on the rumour of ECB bond buying. But when the actual news eventually hits the market, it often results in a sell-off as everyone is already positioned for the good news.

Will that happen this time? Who knows?

At a guess, I’d say gold and gold stocks are due for a correction. Gold has had a stellar month, and hit US$1,300 overnight for the first time since August last year. You can put the recent rise down to worries about the Eurozone…coming QE, the Greeks leaving the zone and the Swiss abandoning the currency peg.

Once ECB boss Mario Draghi makes his announcement overnight, it could give gold an excuse to put in a correction. But by the looks of things, it will be a correction to buy. The currency wars are heating up. Every country wants a cheap currency, in the idiotic belief that you can devalue your way to prosperity. Gold likes this kind of environment.

While you can’t devalue your way to prosperity, you can devalue your way to an election win, as cheap money ‘works’ in the short term. But its long term effects are devastating.

Look at the Swiss. They have the strongest currency in the world and are actively turning capital away by bringing in negative interest rates. And yet they are the richest nation in the world. They got there by following the tenets of sound money, not by trying to win a currency war.

Regards,

Greg Canavan+
for The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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