Personal conversions often mark dramatic turning points in history. In the 4th century AD,
Roman Emperor "Constantine the Great" was convinced that divine intervention was needed before a critical
According to one account, while he was praying, a flaming cross appeared in the sky bearing the words,
"In this sign thou shalt conquer". Constantine was indeed victorious the next day, which ultimately
changed the course of Western civilization, as he immediately commanded official toleration of Christianity
and other religions.
The world of finance also has its momentous conversions. This time the subject is the European Central
Historically, the ECB has been a temple of monetary prudence. The most recent example is its resistance
to partake in the policy du jour, namely, quantitative easing (QE). Germanyís Bundesbank - the EUís most
influential national central bank - has been particularly vocal, condemning large-scale asset purchases
as "illegal and unconstitutional".
To understand the depth of this conviction, one only need look back to Germanyís history in the
20th century. In the early 1920s, the country had a horrific hyperinflationary episode. Then,
after total economic destruction following the World War II, Germanyís currency at the time - the reichsmark
- was virtually worthless.
Fear of similar episodes is now embedded in the national spirit. As an example, a recent poll found
that Germans fear inflation more than getting cancer.
All of this may be changing now. In a dramatic softening of his stance, Bundesbank President
Jens Weidmann recently said that quantitative easing in the eurozone is "not out of the question".
Thatís an enormous policy change and likely the first step toward easier monetary policy and, ultimately, a weaker euro.
Before we outline the important points, consider the number of ETFs that supply exposure to European assets that hedge out the currency risk or short the euro:
Draghi strikes back
To be sure, the ECB is now at a critical crossroad. Since ECB President Mario Draghiís "do whatever
it takes" comments in July 2012, European markets have soared on his rhetorical wings. Bank stocks have
experienced a Lazarus-like revival and peripheral-country sovereign spreads have narrowed dramatically.
Remarkably, Spanish and Italian five-year yields are now below U.S. Treasurys, and the euro has been
on an upward tear against the dollar. This is surely beyond what anyone expected. Just 18 months ago,
fears of a euro breakup were widespread.
But all that is behind us. The relative valuation of eurozone assets is much less attractive now.
Thatís why attention is turning back to the outlook for monetary policy and its implications for the euro.
Below, a list of reasons why the ECB will likely act soon and start a long departure from its "hard
* The "d word". Inflation, as measured by the consumer price index (CPI), has been steadily
ratcheting down in the EU, now running at just 0.5% on a year-over-year basis. To be sure, this is
a very low reading. The ECB has so far downplayed the risks of deflation, citing sagging food and
energy prices as the main cause. However, that analysis misses the mark. The macroeconomics of the eurozone
face a far more deflationary backdrop than any other major regions in the world: Unemployment remains
close to the all-time high of 12.0%; extreme labor market slack keeps downward pressure on household income;
and, importantly, credit growth continues to contract. While thereís some evidence that Europe is healing,
a deflationary trap canít yet be ruled out.
* A chronically strong currency. Euro strength might represent faith in the longevity of monetary
union, but it is creating enormous problems for the region. Currencies are much more important than asset
prices for corporations, exporters, and investors (not to mention globe-trotting ETF strategists).
A strong euro definitely threatens Europeís nascent economic recovery. By contrast, traders are the most
enthusiastic about the euroís strength in almost three years (according to public opinion polls).
The last speculative crescendo in the summer of 2011 was predictably followed by a sharp decline.
Taking a longer view, itís very likely the euroís long-term trend is downward - the last two years
simply being a relief rally as the tail risk of "euro breakup" was removed.
* Germanyís struggling exports. Germanyís chief concern is neither deflation nor financing
its economically weaker southern EU membersí "Club Med". The worry is now about its export competitiveness.
This is the real reason for the Bundesbankís recent soul searching. Perhaps most agonizing are trends
in their export market share to the developing world. After the global financial crisis, emerging markets
really "bailed out" Germany. By mid-2012, German exports to developing countries were 40% higher than
the pre-crisis peak. Since then, Germanyís exports have fallen by more than 10%, with more trade happening
with Japan. This is hardly surprising, as the Japanese yen is 40% cheaper versus the euro, aided and
abetted by the expansionary policies of "Abenomics", the growth-focused policies fostered by Japanís
Prime Minister Shinzo Abe. However, even as measured against other eurozone countries, German exports
are suffering. Excluding Germany, eurozone exports rose 3% in 2013, while Germany saw no growth.
Against this backdrop, a new consensus is emerging in Germany that the ECB should and will do more.
* On a global scale, "doing nothing" is equivalent to monetary tightening. While almost every
major world central bank has been aggressively pursuing QE over the past few years, the ECB has seen more
than €500 billion return to its coffers as banks paid back long-term refinancing operation (LTRO)
loans obtained at the height of the eurozone crisis. Instead of recycling this money back into stimulative
monetary programs, the ECBís balance sheet has been steadily shrinking. Undoubtedly, that is a large factor
in the euroís persistent strength. However, looking ahead, the Bank of Japan will very likely implement
more aggressive QE, particularly as it becomes apparent that Abenomics is not living up to the hype).
How much more yen weakness can Europeís exporters take? Itís now evident that the ECB needs to move quickly
to protect against further euro strength.
The ECBís limited options
Where to next? Ultimately, central banking is a confidence game. Many argue that the ECB has achieved
similar reflationary efforts without engaging in QE or other forms of monetary activism, which is to say
that Draghiís words in the summer of 2012 were enough.
That was true up until early this year. Now, with the above-mentioned factors, the ECB needs
follow-through to maintain its effectiveness. Consider some of its options:
* Lower the main refinancing rate. The currently now stands at 0.25% and cutting it to,
say, 0.10%, would re-anchor short rates to zero. But with rates already so low, how effective would this be?
* Stop "sterilizing" its securities market program bond purchases. This would immediately add
€165 billion of liquidity into the system. Over the short term, a drop in rates would likely ensue,
but it wouldnít likely have any sizable impact on the long term.
* Direct lending. The eurozoneís problem is not liquidity. Banks still have the LTRO facility,
but continue to face bad-loan overhangs and weak demand. This is a big issue. The eurozone is much more
reliant on bank lending, as opposed to in the U.S., where the heavily securitized nature of credit means
market rates are more influential on corporate and household loan rates. The ECB could introduce
a lending program where banks are forced to make loans directly to small- and medium-sized businesses.
A similar program was implemented successfully in the U.K. However, this type of program will not be directly
forthcoming. The reason is the ECBís asset quality review later this year. Under this process,
the ECB will be analyzing the extent of the banking sectorís bad debts and associated recapitalization
measures. Stay tuned here.
* Engage in QE. The ECB could break with its long-running tradition and embrace QE. In other words,
it could be like every other central bank. To be sure, it would have to jump through a host of legal and
cultural hoops to get an "unsterilized" QE program operational (not least of which is the Bundesbank,
even with its dwindling flock of supporters). Still, the combination of a strong euro and low CPI may be
enough to initiate this program.
Unlike Constantine the Great, the ECB may not be seeing blazing crucifixes in the sky. Still,
a philosophical change is clearly underway. This should have been expected. In a world where QE and other
unorthodox monetary measures have become "normal" policy, central banks are forced to conform.
All of this makes for interesting policy debates. What is the "right" course of action for central bankers?
Fortunately, ETF strategists are not paid to determine what "ought" to be. Rather, we are hired to adapt
to and anticipate the global investment landscape for our clients. From our perch, the ECBís range of policy
options point to a weaker euro directly ahead. Tactical asset allocators should position accordingly.
© 2014 HAHN Investment Stewards. All rights reserved. Tyler Mordy, president and co-chief
investment officer of HAHN Investment Stewards,
is a recognized innovator in the design and application of global macro ETF managed portfolios.
He is widely interviewed by the financial media for his global investment strategy views, as well as ETF trends.
CNBC has called him one of the "best independent ETF experts". This article first appeared
in www.ETF.com. Reprinted with permission.