An exciting start to 2015 in Europe

January is off to a brisk start for traders and central bankers in Europe. I see no quick turnaround to Europe’s economic malaise.

The ECB is widely expected to announce a well telegraphed QE announcement this week. The hints going around are slightly higher than I expected, at around 600B Euros. If the ECB is being quite clever they may take a page from public companies and be leaking slightly lower numbers so as to “beat expectations.”

My expectation is that QE alone will not be successful in moving Eurozone inflation back toward its upper bound of near 2%, though any bounce in oil would help, or in stimulating noticeably faster growth in the Eurozone. My argument is the three toos: 2015 is too late because rates are already too low and in any event EUR 600B is too little. I am assuming that QE works through the portfolio channel, and that by taking government bonds out of circulation, cash will have to be deployed in more risky, and hopefully investment stimulating instruments. But rates are already so low in most of Europe that it is hard to see what a slight decrease in rates will do. For example, the Spanish 10 year bond is yielding 1.5% according to Bloomberg, will 1.4% or 1.3% make much of a difference? Though it is possible that after all the hints from Frankfurt, at this point the market is pricing in QE and if they did not do it yields would increase significantly.

What might make a difference would be a large coordinated expansion from countries with fiscal room but this is unlikely to transpire.

What will happen in Greece is different question. An election may usher in a new government which wants debt write-offs. I think the consensus of economists is that Greece will indeed need debt write-offs, though they may need to be hidden in maturity extensions and interest payment deferrals. As the bulk of Greek debt is held by the official sector, this is possible if well enough disguised. I do not see Greece leaving the Euro. They will not leave by choice and being expelled would put tremendous pressure on at least Portugal and perhaps even Italy. If Cyprus can stay in the monetary union why not Greece?

Finally, the Swiss National Bank lifted a three year old cap on the exchange rate of Swiss Francs to Euros. As recently as last month this looked like a rock solid policy and the market was caught completely off guard. One lesson we can draw from this is: there is no such thing as an absolute promise from a central bank. Policies are fixed for a particular purpose and in a particular political context. In this case the SNB has not even convincingly explained why they suddenly ripped off the Band-Aid. A minor point is that the SNB moved deposit rates down to -0.75. If they manage to make this stick, markets paying up for safety in the form of negative interest rates may become more widespread.

Overall, direct implications on the US are negative, though modest. We have seen further dollar strength which will tend to slightly reduce exports and hence growth. The more direct effect is the continued high price in risk-free assets, by which I mean US government bonds. I mentioned a few weeks ago, NY Fed President Bill Dudley has said that when the Fed does raise rates it is going to want to see a genuine tightening in fiscal conditions. US 10 year bonds at 1.85% is unlikely to qualify implying more than just token rate rises when the moment comes.

Notes on oil

The oil market has grabbed the headlines for the last month and this week I made a presentation at the request of a client so I thought I would share a few notes on the blog.

We are in an example of the classic commodity boom and bust cycle. This cycle holds for commodities who’s production requires a substantial amount of investment to produce. So I am thinking more of things like oil, where there is a great deal of capital required to explore, produce and transport oil.

The boom and bust cycle is cartoonishly illustrated below. Something increases the demand and hence the price, new, less effect producers step in, the extra supply reduces the price but the reduction in price does not stimulate enough addition demand to take up all the capacity of the new producers and some of them go out of business. I don’t think I need to tell you where I think we are in the cycle.


While many of us learned in economics that energy demand does not respond very much to price changes in the short run (I need to heat my house in the winter no matter the price) but it is less well appreciated that the demand side is not that sensitive to short term price changes either. This interesting paper by Soren Anderson and his colleagues shows that existing wells continue to pump in Texas despite price drops, though exploration drops.

I also think that the debt financing of smaller, less efficient producers has a role to play too. A producer who borrowed to drill a well is stuck making interest payments and is better off drilling at a loss than leaving the oil in the ground. So we will likely see wells which come to the end of their lives go unreplaced rather than massive amounts of new wells scrapped. We are seeing modest declines in rig counts already.

All this is getting around to me saying oil will probably not stay at $50 a barrel for long. Though I’m afraid I will need to leave “long” undefined.

The industry is not dramatically out of balance. The chart below shows the difference between supply and demand, as calculated by the International Energy Agency. The oil market is murky and these numbers could be off, but they suggest that only a modest decrease in supply or increase in demand will move the market closer to balance, eliding over the issue of high inventories.


Where might the price of oil settle? Well, sadly, I don’t know that either. And in the short run markets can overreact. In fact, given the recent high levels of volatility there would have fairly high expected returns to induce buyers to brave the risk (that is, the price must be low enough compared to fair value, even higher if no one knows what “fair value” is). Suggesting that more declines are possible.

However the chart below, (from the IMF Direct blog via an excellent post by James Hamilton on the subject) while complicated, is worth the effort. On the X axis we see millions of barrels per day, on the Y axes the breakeven range in terms of dollars per barrel. So, one way to think about it would be to say: demand has been between 90 and 95 million barrels per day for the last several years, and the break-even to get that production is someplace in the $60 – $80 / barrel range. For what its worth, that is consistent with the prices of crude oil futures for delivery two years hence.


While good news for most Americans, the oil price drop is not an unalloyed boon, even setting aside the possibility that it signals a decrease in global demand. According to NYU’s Aswath Damodaran The listed companies in the US spent about $900B on capital expenditures in 2013.  (Note that this $900B represents a bit under half of all private, nonresidential fixed investment).  That is a large number, even for a $17T economy.


Were that share to fall by half and the power and utility share to increase by half that would imply an investment drag on the economy of about 0.6%. This should be more than made up by increase in consumptive power by households, especially poorer households with a higher propensity to spend. Nevertheless, it is worth bearing in mind that there effects going in both directions.