One Man’s Opinion: Will The European Central Bank Be Forced Into QE Next Year?

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92835431The European Central Bank is likely to include in their Stress Test the money that commercial banks have raised and the fines they have incurred, said Erik Britton, director at Fathom Consulting.

The eurozone final inflation reading for June came in at 0.5 percent, matching an initial estimate. Asked if investors should take heart since price levels are not falling, Erik answered in negative. The issue in Europe is a highly indebted economy. The peripheral countries, including Italy, are particularly highly indebted.

The trouble with debt is that when inflation falls, it becomes a toxic mix. It turns out that, in Italy for example, an inflation rate of sub 1 percent is good enough for the economy to be on an unsustainable path. Italy’s inflation has been trending downwards for the last couple of years along with the rest of eurozone and that process is likely to continue as the economy is in a recessionary environment, he noted.

Asked if the ECB should do more given the great deal of resistance to quantitative easing from the governing council, Erik answered in affirmative. The ECB will be forced to do a QE because of the deflationary trend in the euro area. Price levels are bad enough as things stand, and they are getting worse. The ECB will be forced into a full, unsterilized QE by the first/second quarter of next year, similar to the ones undertaken in countries such as the UK, Japan and the US, he observed.

Asked if further sanctions on Russia could be one of the swing factors for quantitative easing as it might affect energy prices, Erik said higher oil and gas prices could affect the global economy. However, the way markets are pricing in risks now implies the volatility of oil prices is at an all-time low. The risks are not much more pronounced than they have been in the past. Looking at the events in Ukraine, Iraq, Nigeria and Venezuela, it seems pricing risks are at an all-time low, and it’s possible they will affect growth in Europe, he argued.

Asked to comment on the effects of announcements made by ECB President Mario Draghi, Erik said Draghi has, essentially, written a put option on the value of the peripheral euro-area sovereign debt. He has issued that put option free to the markets though an option has a value, irrespective of whether it is exercised or not. The value of that put option now runs into, with asset prices where they are, 20 billion euros or so.

The period when the risks in the sovereign debt market in Europe were high, the value of that option was about 700 billion euros, which is a large number. That resulted in the narrowing of spreads between the peripheral and the German bonds. It happened due to Draghi’s “whatever it takes” rhetoric and had nothing to do with structural reforms in the periphery, he concluded.

You can watch the video here.

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