Europe's Unprecedented Rate-Slashing Gives Us a Classic Profit Play
Interest-Rates / ECB Interest Rates Jun 11, 2014 - 03:37 PM GMTBy: Money_Morning
Peter Krauth writes: European Central Bank President Mario Draghi is desperate.
The European Union has been plagued with years of falling inflation and stubbornly high unemployment.
And now its central bank is attempting to employ "unconventional" policies to kick-start the economy.
Using tactics never tried before, the ECB has just entered uncharted waters.
But if we look at the history, we'll see the perfect opportunity to profit...
Europe's Next Great Experiment Begins...
Last Thursday, after months of thinly veiled hints, the ECB took drastic measures.
Some of the central bank's key moves included:
- Interest on main refinancing operations (MROs) was lowered by 10 basis points to 0.15%. These are loans to banks secured by sovereign debt.
- 400 billion euros were made available in loans to banks with a limit of up to 7% of existing loans to the nonfinancial private sector (excluding home lending).
- Marginal lending facility (overnight credit from ECB) was lowered from 0.75% to 0.4%
But the real kicker...
- Deposit rates (interest paid to banks on deposits at the ECB) were lowered from zero to negative 0.1%. Banks will now have to pay the ECB to leave funds on deposit. This is exactly what I highlighted back in mid-April.
It's a move no other major central bank, not the Fed, not the Bank of England, not even the Bank of Japan, has yet tried.
So what's the goal, and will it work? As it turns out, we can gather clues from some precedents.
The Velocity of Money Is a Problem
The ECB is similar to the U.S. Federal Reserve in that it issues the official currency, the euro. It also sets interest rates to help guide the economy, and it supervises commercial banks. But its top job is to keep inflation under control. The Fed has similar goals, yet has a "dual mandate" that includes seeking low inflation and high employment.
So let's look at the problems the ECB faces.
Europe's been mired in a "low-flation" state since 2011, with inflation actually decreasing over the past two and a half years to 0.5% in May, considerably under the 2% target.
This can be a problem in that, if it goes on for an extended period, markets will begin to expect falling prices, or deflation. Those expectations can drive consumers to delay spending as they assume they can buy things for less in the future, thereby retarding consumption.
Europe's other big problem is unemployment.
Though it's been declining (albeit very slowly), right now it's still high at 11.7%, but youth unemployment is astronomical at 23.5%. In Greece and Spain? Forget it. There, youth unemployment sits at 56.9% and 53.5% respectively.
These are big problems, so the ECB has begun pulling out the big guns.
Their hope is that these across-the-board rate cuts are going to stimulate activity and boost the economy through increased lending, as well as by accelerating the velocity of money. In turn, higher economic activity levels should also lead to higher employment.
And while there may not be precedent for negative rates on such a grand scale, it's actually been attempted in Denmark and Sweden recently.
As I mentioned in my article "Get Your Share of an Extra Trillion Euros," Denmark has had negative interest rates since 2012. Thanks to that genius policy, Danes have become the most debt-ridden people in the world. No more bragging rights for us.
Denmark's neighbor Sweden tried negative rates during the financial crisis. But their central bank saw no benefits, and that policy was soon reversed.
So now Europe is going to try this questionable plan on a grand scale.
Will it work?
I'm skeptical.
But consider this. The Fed lowered rates leading up to the 2007 market top. We all know how well that ended.
So of course the Fed went ahead and lowered rates again in the aftermath of the financial crisis and still today promises to keep them near zero for an extended period. Many believe they will be kept low longer than anyone can imagine.
And they also did a whole lot of printing, and still are, to buy up Treasurys and mortgage-backed securities.
It's true that U.S. stocks are hitting all-time highs. And that, too, can continue longer than most can imagine. But some of the savviest investors around believe it's all going to end badly, much worse in fact than the last financial crisis.
Japan's tried similar tactics on an even larger relative scale, with limited success. It may try even more.
No Matter What Happens, We'll Make Money
As for Europe, the goal is of course to reflate assets in hopes of kick-starting economic activity and inflation.
But on a wider scale, the risk is that banks will take on riskier lending practices for yield, possibly fueling new asset bubbles and an even taller house of cards.
All of this should sound familiar, given that it's exactly what originally led to the 2008 financial crisis. History, it seems, has taught some of us absolutely nothing.
So yes, the ECB may get what it wants. But there's also the risk that these policies will only have a limited effect.
If that's the outcome, Draghi's ready for that as well.
During the last ECB policy meeting, Draghi clearly stated that the ECB was receptive to the idea of using quantitative easing (QE), much like the Fed bought mortgage bonds, corporates, and even sovereign bonds to "de-risk" banks and inject liquidity.
Draghi said the central bank was intensifying preparation, fine-tuning a plan to eventually buy asset-backed securities, a strategy that so far has been successful in elevating U.S. and UK stock indices.
Though I'm concerned about the longer term and final outcome, there's clearly some money to be made on this trend in the near and medium term.
In order to profit from this setup, you could simply make a bet on rising European indices through a straightforward European shares ETF.
But I prefer to play two trends, one of which is likely to move higher even without European stimulus, but which is sure to see additional benefits from it.
Consider the iShares S&P Global Healthcare Sect. (ETF) (NYSE: IXJ). While not a pure European play, it has one of the highest non-U.S. exposures in healthcare, most of which is European, and trades at a more reasonable P/E of 19. The fund is up 8.44% year to date and recently set a new all-time high, so it's definitely got momentum on its side.
Remember, Europe is finally coming around to using the same strategies as the United States as far as central bank policies are concerned.
But with even worse problems to address, odds are tactics used by the ECB may end up being even more extreme.
Negative interest rates have arrived in Europe. The scary thing is the ECB just might get what it wants... and then some. I believe that will ultimately come.
Either way, the ECB is getting ready to use QE, the financial nuclear option, on a grand scale. And with this ETF your profits are poised to rocket.
Money Morning/The Money Map Report
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