Mario Draghi, the head of the European Central Bank (“ECB”) has been vocal over the past few months about the need to devalue the Euro.  His first step in pursuing this objective was to cut the bank deposit rate to -.10%, which he says will also help to fight off deflation.  However, there are other good reasons to implement this strategy.  Two of those are to spark economic growth and to lower the unemployment rate.  If the Euro falls in value relative to other currencies, European goods become cheaper on a worldwide basis and the ECB member countries could then benefit from increased sales.  As for unemployment, rates are very high throughout much of the Eurozone, exceeding 10% on the whole.  In particular, the southern European countries’ unemployment rates are much higher with Spain’s rate at 25%, Portugal hovering around 15% and Greece’s rate at a lofty 27%.  High unemployment causes discontent.  One of the manifestations of this discontentment is the big gains made by anti-European Union parties in the EU parliament in last month’s elections.  Despite all of this, we believe the real reason for going negative might be to fund government debt at artificially low interest rates.

The biggest risk with deflation and high government debt levels is the inability of governments to service their debt.  As you can see from the chart below, the debt levels of the PIGS are all over 100% of GDP (Spain will be there in the next few months) with Greece back to the level it was at before investors took hair-cuts!  One of the five requirements of the Maastricht Treaty – the treaty that created the EU – was that each country’s debt-to-GDP ratio shall not exceed 60%.  What is interesting is that these debt levels have grown during a time of so called austerity.  Real austerity would be full compliance with the EU treaty.

The biggest near-term impact of the ECB’s negative interest rate policy was to force banks to remove deposits from the ECB.  What did the banks do with that money?  It appears that they have invested the money in the government bonds of these highly indebted European countries.  As a result of this reallocation of assets, interest rates in these countries have fallen to a level that is equal to or lower than the rates in the United States.  As the ECB is prohibited by law to finance country debts, it appears it is forcing banks to do so.  This is a lesson it learned from our own Federal Reserve.

We all know the Fed is tapering its purchases of Treasuries by $10 billion each month and it appears they are tightening.  However, the Fed is also the regulator of banks.  Can they force banks to buy Treasuries in order to keep rates artificially low?  The answer is yes.  In early April, the Fed did just that by raising bank requirements, forcing banks to boost their capital by $68 billion.  In other words, the big banks were compelled to buy $68 billion of US Treasuries.  The biggest question is – are the banks now taking excessive risk buy buying country debt?  We believe the answer is yes, but it might take years to find out the true impact of going negative on interest rates and forcing banks to buy country debt.

 What does this mean for investors?

Investors should be leery of investing money in European bonds or currencies – especially the Euro – at this time.  Why invest in these low-rated bonds when you can get a higher return investing in the United States?  Draghi is determined to devalue the Euro and we believe this is just the first step to do so.  If you are planning a trip to Europe, things could be much cheaper if you delay your trip until Draghi is successful in bringing down the value of the Euro.

Interesting fact – Student loan debt ($1.11 Trillion) is now larger than credit card debt ($857 Billion).