The week of January 19 saw two of the decisive events that market participants had been waiting for. The first, on Thursday, January 22, was the European Central Bank’s (ECB) announcement of €60 billion per month of quantitative easing (QE) until at least September 2016, with no set end date, and enough risk-sharing to mute the naysayers. That we effectively knew this was coming should not detract from the significance of the news. The euro itself fell by around two and a half cents, reflecting the extent to which the central bank had surprised even those who thought they knew what was coming.
The other was the Greek election on Sunday, January 25, and the widely anticipated victory of Alexis Tsipras’ Syrizia party, pledged to renegotiate the austerity agreements with the so-called Troika of the European Union (EU), the ECB, and the International Monetary Fund (IMF). Unlike the 2012 elections, Tsipras is no longer an unknown quantity and has spent months meeting with Europe’s political leaders. We can expect hard negotiations—commentators have referred to games of “chicken”—but the central case is for compromise. Also unlike in 2012, there is reason to believe that in the event of a miscalculation and a Greek exit, the risks of contagion would be reduced considerably. When making these statements, one inevitably thinks of bland assurances around the time of Lehman Brothers. But at risk of stumbling into other unintentionally humorous clichés, this time it does seem to be different. Chart 1 below shows holders of European debt. There are almost no private holders of Greek debt any more. There is little risk of capital flight, because the capital that could flee by and large has. Bank runs are a feature of a psychology that is profoundly unpredictable, but it is fair to believe that bank account holders in other peripheral countries such as Portugal view Greece in much the same way they saw Cyprus: a cautionary tale, and not a domino teetering in their direction.
Indeed, there are now only really three impediments to a Greek exit. Of all the interesting facts and analogies that circulated around the time that a Greek exit was first mooted, some of the most interesting were around notes and coins. Banknote printer De La Rue estimated the minimum time to launch a new currency as four months, and this references Iraq, a country which at the time US authorities embarked on the exercise had virtually no electronic banking and was literally under military control. Economic forces will eventually swamp the merely practical or convenient, but it is worth bearing in mind that comparisons with depegging are well off the mark. Accidents happen, but the logistics of a planned exit are hard to execute.
The second factor that is also under-appreciated, particularly outside continental Europe, is the extent to which the single currency is seen as one aspect of a political project, and part of that project is solidarity. Nothing about how the EU behaves indicates that this is a mere slogan. The idea that a partner should be aided and not hung out to dry is central to that. Here too, willpower alone cannot change realities, but the strength of that willpower has been consistently underestimated since the Maastricht Treaty set the train of convergence in motion. The third is that no one wants Greece to leave the euro, and a party with its first taste of government leads that list, for all that it flirts with the possibility. European policymakers have shown a love of brinkmanship and a fondness for coming to agreement only in the wee hours of Sunday nights. A wise investor would expect volatility; prepare for the worst, but bet on compromise.
Owing to these two events, few observers focused on one which in its own way may prove to be just as significant: Bank of England (BoE) Governor Mark Carney’s comments at the Davos World Economic Forum on Friday, January 23. “We have a very low inflation environment right now, largely caused by commodity prices and an ability to look through that,” he said (emphasis added). “We have the means, the responsibility and the will to return inflation back to target in the two-year horizon.” He went on to say, “It is not lost on us that wages are picking up now in the most recent data and [are] consistent with our expectations.” His other comments are hard to read in any other context than former Federal Reserve (Fed) Chairman William McChesney Martin’s famous aphorism that its job was, “to take away the punch bowl just as the party gets going.” Carney all but described the festivities, noting, “[i]n an environment of low interest rates and low inflation for a period of time, and also QE, there can be excessive risk-taking… We are particularly concerned about an illusion of liquidity that has existed in a number of financial markets. I would say that illusion of liquidity is gradually being disabused.” We could paraphrase as follows. Low inflation is a transitory phenomenon caused by falling oil prices. Low inflation is increasingly no longer evident in UK wage claims. There may be excessive risk-taking in other areas of the economy, exacerbated by easy policy.
Is this a shot across the bows signaling imminent rate hikes? Likely, no, it is not. But one should listen to what the Governor of one of the world’s more important central banks has to say, particularly when it echoes comments made by New York Fed President Bill Dudley last month. We expect no fireworks from the Fed at this week’s meeting. Equally, those pushing out the timetable of Fed hikes to 2016 may be building their case on a shakier foundation than they believe.
Head of Absolute Return
Written on January 23, 2015
Chart 1: Analysis of the holders of European sovereign debt at the end of 2013 (there are good grounds to believe there were no meaningful changes to this analysis in 2014).
Source: Arslanalp and Tsuda (2014). DB Global Markets Resarch
Fischer Francis Trees & Watts (FFTW), a wholly owned subsidiary of BNP Paribas, is a global investment company providing active, fixed-income capabilities across global, US and emerging markets to institutional investors.