The ECB Meeting: Expect the Unexpected

Negative rates could be on the board when Draghi speaks Thursday

The European Central Bank governing council meets tomorrow, and President Mario Draghi is expected to pull a few policy rabbits out of his hat. Based on the recent strength of European stocks, as measured by the Vanguard European Stock Index ETF (VGK), investors are expecting something big, such the launch of a Fed-style quantitative easing program.

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So, what’s all the commotion about? Why the sudden pressure for Draghi to act?

One word: Inflation. Or more accurately, a distinct lack of it. Inflation in the eurozone fell to a five-year low last month to just 0.5%, and the fear is that Europe will sink into outright deflation.

Deflation — or falling consumer prices — sounds delightful at first blush. Who wouldn’t like to pay less for the items they buy?

But deflation can create a slow-growth trap from which it can be dreadfully hard to escape. The expectations of lower prices becomes a self-fulfilling prophecy, and aggregate demand gets sucked out of the system. It is no coincidence that prices are falling in Europe at the same time that eurozone GDP growth has slowed to a crawl — just 0.2% as of last quarter.

Just ask Japan. Its recent flash of inflation notwithstanding, Japan has been fighting off deflation for more than two decades now, and its economy has been in suspended animation.

Draghi promised two years ago to “do whatever it takes” to save the euro. Preventing deflation from setting in is the single most important priority for him in keeping that promise.

So with that said, what should we expect tomorrow?

Draghi has teased us with talk of negative interest rates and bond-buying programs, but he’s been short on specifics. Here is what I expect tomorrow and what I suggest you watch for:

  1. Draghi will almost certainly cut the ECB refinancing rate (its equivalent of the Fed funds rate) from 0.25% to probably 0%. Alone, this policy move will not amount to much, as rates are already very low. But it is symbolic and sends a signal to the financial markets.
  2. Draghi probably will introduce negative interest rates on the deposits that eurozone banks hold at the ECB; currently, rates are at zero. The idea here is to spur Europe’s banks to actually do something with their cash rather than leave it on deposit at the central bank.
  3. Draghi may introduce a quantitative easing program that, like the Fed’s, injects record amounts of liquidity into the financial system by buying bonds.
  4. Draghi may reintroduce his Long-Term Refinancing Operation (“LTRO”), which provided virtually free three-year financing to eurozone banks during the pits of the sovereign debt crisis when the market seized up and other financing options evaporated. I consider this option less likely, as no bank wants the negative stigma associated with borrowing under LTRO, but some revised form of LTRO is a possibility.

What would these policy options mean to investors?

I don’t expect a cut to the refinancing rate to make much of a difference at all. A drop from 0.25% to 0% just isn’t that significant. The negative interest rates on deposits are a different story, however. I do not see negative interest rates spurring European banks to lend to real Main Street businesses. But I would see them spurring banks to pull their cash out of the ECB and pour it into sovereign debt and high-quality corporate bonds. The result should be lower bond yields across the yield curve.

And what about quantitative easing? This is the potential “big bazooka” that could send Europe’s financial markets into overdrive the way that the Fed’s quantitative easing did here in the U.S.

There are a few problems, however. Germany has been against bond buying, considering it direct financing of eurozone governments, which is illegal. However, Germany has recently hedged this position. Earlier this year, Bundesbank President Jens Weidmann said that QE was not “out of the question,” though he preferred that the ECB buy non-governmental debt.

Expect any announcement on QE to be somewhat convoluted and muddled. Alas, this is the way things are done in Europe to keep all relevant parties happy.

How should investors proceed?

I wouldn’t recommend you run out and buy eurozone bonds, even though I see their prices rising. Yields are simply not high enough to compensate you for any loss in value due to currency moves.

Instead, I would recommend you take a look at European dividend-paying stocks. One brand new ETF option would be the WisdomTree Europe Dividend Growth ETF (EUDG).

EUDG has only been trading for about a month, and volume is still very low. But the ETF is one of the most direct ways I have found to date to play European dividend stocks. The portfolio is a virtual who’s who list of high-quality European dividend payers — names like Daimler (DDAIF), Siemens (SIEGY) and Anheuser-Busch InBev (BUD) — and its underlying index currently yields 3.2%.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long DDAIF and SIEGY. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.

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