Category Archives: On the cover

On the cover

The ECB Must Stop its QE Program Now. Here is Why.

Europe, Global Economy, On the cover, Sin categoría

This week the European Central Bank has announced that it will maintain its asset buyback program, despite the fact that the European Union is neither in crisis nor in a recessionary shock. This is the first time in history that major central banks are making repurchases in excess of $200 billion a month without being in a period of crisis.

The European Central Bank launched a fresh defense of its monetary policy, saying that low interest rates and monthly asset purchases of €60bn have helped to stimulate growth and jobs in the eurozone and prevented the bloc from sliding into deflation.

“Our monetary policy was successful. The question is: is it time to exit or time to think about exit or not? This time hasn’t come yet,” he said. I am afraid he is wrong, ignoring financial risk accumulation and perverse incentives in over-indebted governments.

The growth figures of the European economy are good, and manufacturing indices are expanding. But they were already in expansion before QE was launched. The European manufacturing PMI is at six-year highs, the expected growth for 2017 will be 1.7% and 1.8% for 2018, unemployment will fall to 9.4% and 8.9% in 2017 and 2018 respectively, and growth of investment and credit is close to 2.5%. However, inflation by decree has been a failure, rising in energy and food prices and poor in core underlying inflation, a consequence of accumulated overcapacity and poor productivity.

You could say that these good growth figures are because of the ECB policy, but Europe was already expanding and recovering before they bought a single bond. Europe has been improving for five years. But that is not the debate. Even if we assume, for a moment, that the ECB policy has “worked” -despite 1.2 trillion euro of excess liquidity and high-risk bonds at the lowest rates in thirty-five years- the ECB must stop the monetary laughing gas urgently, for several reasons:

It runs out of tools before a cycle change. With zero interest rates, buying in some issues up to 100% of bond issues’ supply, and with new debt financing governments’ current expenditure and low productivity investments, whenever the economic cycle changes – and it does -, the central bank will have run out of its only historical tools.

After 600 rate cuts and buying tens of billions of dollars per month, it would create a boomerang effect that would generate more stagnation, Japanese-style. Anyone who thinks that the central bank can put negative types and increase money supply further and change everything is dreaming. What has not worked from 5 to 0% will not work from 0 to -5%. Financial repression does not lead agents to take more risk and invest, but to be more prudent, to hoard on liquid and safe assets, because monetary policy encourages over-indebtedness and perpetuates imbalances.

The ECB has already gone beyond the Fed. The ECB’s balance sheet already exceeds 36% of the Eurozone’s GDP and controls 10% of corporate bonds, a “nationalization” of the corporate debt market of almost 1% per month. In the case of the US, the Fed is c10 points below. Only the Bank of Japan surpasses the ECB, and we already know the level of debt and stagnation that the country has. The risk of following the path of Japan is not small.

It does more harm to the financial sector than benefits to the real economy. The bankruptcy of the zero-interest-rate policy is unprecedented and jeopardizes the consolidation process. Non-performing loans remain above 900 billion euros, operating margins and solvency ratios have plummeted to the lowest levels in a decade, and since the program was launched, Europe has seen three banking shocks, in Portugal, Italy, and even Germany. The impact on the financial sector is not compensated by the alleged economic improvement (a loss of almost 90 basis points in margins versus a slight increase of 15 in financial sector results, according to Mediobanca).

It does not help SMEs or families. While the ability to repay debt has not improved and cash or credit ratios remain poor, zombification of the refinanced sectors is soaring. High-yield is at the lowest interest rate in at least thirty-five years. Governments have saved more than 1 trillion euros in interest on the debt, of course, but, to my surprise, they have spent it all, and the ability of most European Union governments to adapt to an increase of only one 1% in the cost of debt is extremely low.

This leads to a rising tax burden despite the massive transfer of wealth from savers to governments, and – with it – it is extremely complex for SMEs and families to receive the slightest benefit of this extreme liquidity. Only 1% of SMEs have sought new credit, because their costs, excluding labor, have grown almost ten points more than their revenues, and of the meager 29% who requested a loan, only 69% received the required amount, according to the ECB. Despite extreme liquidity and low rates, demand for solvent credit remains very poor.

The huge risk of a bubble in bonds and financial assets is not offset by the supposed benefits of keeping the quantitative easing program. If we do not understand that accumulated risk is the root of the next crisis, we will repeat the mistakes of 2007.

Ignoring the risks that monetary policy generates in financial markets is very typical of central banks. It is thought that they can be mitigated, that they are acceptable and that they are not dangerous. And they are. They will be. Getting used to abnormally low rates and excessive liquidity to perpetuate imbalances is a huge risk. Not preparing for winter is suicidal.

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google

OPEC strategy has backfired. And it could get worse

Energy, Global Economy, On the cover, Sin categoría

Nervousness is palpable ahead of the next OPEC meeting in Vienna. The cut in production agreed with some countries such as Russia has been an absolute failure. Not only OPEC has failed to raise the price of oil, but the market share of their main producing countries has been reduced.

If anyone would have told Saudi Arabia that the deal would push the price of oil to its lowest level in six months, increase its main rival’s market share, and strengthen the fracking industry in the US, they would not have believed it. And that is exactly what has happened. No one can say I did not warn them.

Iran expects to increase production capacity by 3 million barrels a day according to the Shana news agency and official sources. Iraq remains at record levels, exporting 3.2 million barrels per day.

In the United States, shale alone has boosted production to 5.2 million barrels a day in May, 700,000 more than at the end of 2016. Between the increase in output of Iran, Iraq and the United States, they cover almost all of the cut agreed.

Iranian and Iraqi barrels are of the highest quality and very low cost, while US production costs have been brutally reduced. BP, in its earnings presentation, commented that its production in deep waters in the Gulf of Mexico can compete without problems with a shale production that already has a break-even price of c$45 a barrel. Thanks to efficiency and cost reduction, production in the Gulf of Mexico has also skyrocketed, bringing total US production to 9.3 million barrels per day, the highest level since 2015.

The OPEC cut has been the biggest gift to independent producers who have improved efficiency. It has allowed them to generate better returns at low prices, and increase market share.

Meanwhile, Saudi Arabia is the only country that has exceeded its commitment – as always – and delivers the biggest cut of all.

The price of oil is suffering because production is increasingly diversified and, as such, the geopolitical premium we attach to crude prices disappears and the ability to control prices of OPEC diminishes. Not only that, but inventories are at a five-year high, and have increased in the US by 10% since the OPEC cut, 30% above the average of the last five years.

The mistake of inflationists with the price of oil is threefold:

  • To think that the reduction of investments will generate a boom in prices in the medium term. Not only is capex growing at an annualized 8%, but they forget that the “reduction” came after a spending bubble in the easy money decade that led to a huge productive overcapacity of close to 30%. Investments in exploration and production multiplied in ten years to more than $1.2 trillion per annum, fueled by inflated commodity prices – in dollars – due to monetary policy and estimates of science fiction-style Chinese  growth, with no fundamental justification and based on bubble expectations. Today, those massive investments have become sunk costs and work just to generate cash. What we call “energy broadband” in The Energy World Is Flat (Wiley).
  • Ignoring efficiency and technological substitution, which are unstoppable and withdraw each year, according to the IEA, up to 2 million barrels a day of potential demand. Many think that OPEC cuts will work as demand grows. Let us not forget that, as soon as the demand begins to work better -and it is not bad- OPEC will start to “cheat” on those cuts, as it has always done, since there are no individual quotas and, when there are, many ignore them . To give you an idea, the average “cheat” in OPEC cuts since 1980 is between 450 and 800,000 barrels a day.
  • The lower the price, the more efficient the system. Global service companies have shown in their results this quarter that they can lower prices by 40-45% and still make money and grow.

OPEC strategy has backfired. But it can get worse. If consumer nations continue to perceive that the cartel is not a reliable, flexible and efficient supplier, and that its aim is to raise prices at any cost, the policies to reduce energy dependence will accelerate, just as solar and wind are becoming more competitive and electric vehicles are a reality. OPEC does not have a cost or profitability problem. All countries are making very positive returns at $45-50 a barrel. Those that are not making money is because they have massive cross-subsidies and political spending, not high production and development costs.

Many will tell you that “in the medium term” the market will balance … And they said the same thing two years ago, a year ago, six months ago… But they ignore that balancing does not necessarily mean price inflation. Because the technology, substitution and diversification revolution is much faster than the interventionist decisions of central planners.

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google

 

Video: Outlook for the Euro, Oil and Stocks after the French Elections

Global Economy, Media, On the cover, Sin categoría

In this short video, I explain our view of the EUR/USD short-term, why oil remains subdued despite OPEC cuts and the earnings season so far, with implications on stock markets.

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Tressis

 

Euro vs US Dollar. Time to sell?

Global Economy, On the cover, Sin categoría

After the French elections, the euphoria over the euro/dollar exchange rate is more than likely to dissipate. The revaluation of the European currency has been supported by consecutive political catalysts, which have supported the Eurozone project, and the trade surplus supports the euro versus the main currencies with which it trades.

Once political news have passed, and focusing exclusively on fundamentals, supply and demand should prevail. There are several challenges:

– The global demand for euros decreases . The latest figures from the Bank of International Settlements (BIS) show total cross-border transactions in US dollars of $ 13.9 trillion, increasing by $60 billion in the third quarter of 2016. In turn, transactions in euros fell by $160 billion, to a total $8.1 trillion.

– Supply of euros rises. We are in a dangerous time. For the first time in history, central banks are increasing money supply by more than $200 billion a month without any crisis or recession. Of that figure, the European Central Bank is almost a third. At the close of this article, this enormous monetary expansion has already generated 1.2 trillion euros of excessive liquidity.

Confidence in an export model and the trade surplus of the European Union, which makes the reserves of foreign currency of the Eurozone grow steadily, have been the main factors behind the relative strength of the euro. It shows that the European economy is more solid than some inflationists would like it to be.

The evidence that devaluation does not favor exports is clear in the Eurozone. Since the launch of the ECB program, the euro has weakened almost 23% against the US dollar and yet export growth has slowed significantly. In fact, the most sustained increase in exports has been between countries of the euro area itself, that is to say, with no currency effect, while growth in exports to non-euro countries has weakened considerably. However, inflationary alchemists will continue to tell you that devaluing supports exports.

We must not forget the challenge of supply and demand, and of excess liquidity. The European Central Bank is almost 200 bps behind the curve and should be raising rates already. In addition, with such an amount of excess liquidity, which increased by more than €1 trillion since the repurchase program was launched, it is urgent to drain that excess and stop increasing the ECB current balance sheet. There is enough liquidity in the system to continue supporting bond issuances.

It is more than likely that the supply of US dollars will be contained, through the normalization of the US monetary policy, where the Federal Reserve also lags far behind the curve by almost 300 basis points, while global demand of the US currency increases, mainly from emerging countries. While demand for dollars is growing above supply, the reverse is true of demand for euros versus supply.

Therefore, apart from political catalysts, markets are facing a few years in which the euro is more than likely to lose momentum with respect to the US dollar.

We must pay attention to the risk of loss of confidence in the European currency if excessive liquidity continues to rise while money supply is increased. The last thing the EU would wants is to lose the status of the euro as a reserve currency. It must leave alchemist experiments behind and aim to strengthen the demand for euros in global transactions.

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google Images