It’s all come down to this.
After years of teasing a large government bond purchase stimulus, and whetting appetites with other stimulus efforts such as three-year bank loans and covered bond purchases, the European Central Bank (ECB) can postpone no longer. The decision will come Thursday morning.
Deflation is taking hold in the eurozone. Factory activity in major countries like France is declining outright. And a surprise move by the Swiss National Bank to end its peg to the euro — ostensibly out of concern a new “Euro QE” program would tank its valuation and raise the cost of the intervention — has market expectations white-hot that the ECB will act.
With such a big hurdle on the horizon, stocks were little changed on Wednesday. In the end, the Dow Jones Industrial Average gained 0.2%, the S&P 500 gained 0.5%, the Nasdaq Composite gained 0.3% and the Russell 2000 lost 0.3%. Crude oil rebounded slightly to close at $47.55 a barrel. Safe havens suffered profit taking, with both Treasuries and gold moving lower.
ECB officials are trying to downplay the importance of all this, with Governor Ewald Nowotny telling an audience in Vienna this morning that we all “shouldn’t get overexcited” about the announcement.
Yeah, right.
Alberto Gallo at RBS, who specializes in following European credit markets, penned a tongue-in-cheek response to Nowotny saying that investors and traders aren’t feeling excitement. It’s beyond that. In his words, the “ECB announcement may be one of the most anticipated moments since the crisis.”
Here’s where things stand on the key issues:
- Size: Currently, the market expectation is for a program of 600 billion euros, with the high-side whisper estimate near 1 trillion. Gallo believes the size of the program will be the most closely watched metric by the market.
- Risk Sharing: While size will get the headlines, the amount of risk sharing is arguably more important. In an ideal world, the risks of default by a weaker country like Greece would be borne by the entire eurozone to move the currency area closer to fiscal integration. For political and legal reasons, this is unlikely to happen. Gallo estimates that about 80% of the program will be done by individual national central banks — keeping the risks of default quarantined to individual countries.
- Impact: Gallo notes that 52% of RBS clients polled believe the ECB’s QE program will have an impact on financial markets, but only 4% believe it will be successful in raising growth and inflation. As a result, he believes the program will merely buy Europe time without solving its structural problems.
When growth falters and deflation deepens, markets will ask: What now?
In the near-term, however, initial excitement should help stocks bounce higher (with a small but not insignificant chance that the ECB disappoints and sends markets into a tailspin).
In response, I’ve recommended clients move to cash by booking profits in their defensive positions. Examples include the 46% gain captured by Edge subscribers in the VelocityShares Daily 2x VIX Short Term ETN (TVIX) between Dec. 1 and Jan. 20 as well as the 74% gain in Facebook Inc (FB) Jan $77.50 puts bagged by Edge Pro subscribers between Jan. 7 and Jan. 15.
I continue to believe that precious metals stocks have upside potential amid the increase in currency and commodity market volatility. I reviewed a handful of stocks in the area in galleries here and here.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters.
