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Whereas some members of the governing council of the European Central Bank
were hinting the monetary policy would return back to ‘normal’ sooner rather
than later, Mario Draghi, the president of the ECB, had a completely
different opinion when he testified at the European Parliament.
According to Draghi, all stimulus
measures need to remain in place until the Eurozone returns to a
normalized inflation rate, and reducing the efforts of the ECB aren’t even
being discussed.
Draghi did confirm the economy of the Eurozone is getting stronger thanks
to domestic consumption and investment (rather than seeing a boost caused by
external investment and export increases), but it’s still too soon to reduce
the asset purchase program which will now very likely be extended.
Source: tradingeconomics.com
The ECB has also published its ‘Financial
Stability Review’, which assesses the risks and vulnerabilities of the
financial system as we know it. According to the ECB, the measures of the
systemic stress levels in the Eurozone remained very low
thanks to a slight increase of the interest rates which increased the
confidence the European financial sector will be able to benefit from a
larger interest rate spread to strengthen their performances and balance
sheets.
This doesn’t mean the financial sector is out of the woods yet, as the ECB
is explicitly warning for specific countries where the Non-Performing Loans
are ‘eating away’ the profit generated by the interest spread. There’s pretty
much zero doubt the ECB is referring to Italy here, and we discussed the
country’s situation last week in
this article. As you might remember, two Italian banks which were
previously rescued by the tax-payer through a government fund once again need
an urgent cash infusion to prevent a collapse.
And whilst higher interest rates on the financial markets are excellent
news for the financial sector, the ECB also acknowledges these higher
interest rates might actually suffocate both the private and public debt
issuers. Not only will the governments have to cough up more cash to fund the
interest payments on their government debt, the private sector has greatly
benefited from the low interest rates. Just like in the USA, companies issued
much more debt than they needed, only to spend it on non-accretive things
such as share buybacks and special dividends. One good example here might for
instance be Bayer’s attempt to acquire Monsanto in a $66B
deal. Bayer was (and still is) planning to fund the entire acquisition
with debt. A 1.5% increase in the cost of debt will result in Bayer paying
$1B per year more in interest expenses. So it shouldn’t be a surprise the ECB
is now also calling higher interest rates one of the main potential systemic
risks.
Source: ECB
And that’s a little bit a contradictio in terminis. The ECB wants
the inflation to increase which would allow it to normalize the benchmark
interest levels, but if the interest rates increase without seeing a
corresponding increase in the inflation rate (the natural effect of companies
passing the higher price levels on to their consumers is a very unhealthy
situation.
The higher interest rates for private companies are one part of the
equation, perhaps an even more important part is the total debt level. And
this is where the ECB is sounding the alarm bell as well. According to data provided by the OECD, the private debt in the
Eurozone is higher than the historic average, ànd is higher than for instance
Japan, the USA and emerging market countries.
Source: ECB
This data confirms the ECB would be nuts to stop its ZIRP and to reduce
the asset purchase programme. The interest rates would increase too fast, and
possibly push the Eurozone over the cliff again. We told you this before and
will do so again; once you’re addicted to cheap debt, it’s really difficult
to detox.
The end result? Tens of billions of freshly-printed euro’s will continue
to be injected in the system. And it’s not a question of ‘if’ it will go
wrong, but a question of when it will go wrong.
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